Could there be a major currency risk on the dollar? Could we face with a situation where the dollar depreciates sharply despite the higher interest rates in the United States? The risks of a steep depreciation of the dollar could stem from: n An increase in the US external deficit (in the US external debt) as a result of the expansionary monetary policy conducted at full employment;n A downward revision of the growth outlook for the United States, as full employment normally brings growth back to the lower level of potential growth, which could lead to a lack of confidence in US equities among non-residents. But the US tax reform will, on the contrary, boost the equity market;Flash Economics 03 May 2018 - 504 n A trade war between the United States and other countries (China), driving these countries to retaliate by reducing their purchases of financial assets in dollars.Patrick Artus Tel. (33 1) 58 55 15 00 patrick.artusnatixis.com PatrickArtus www.research.natixis.comCe document est distribu aux Etats-Unis. Merci de lire attentivement lavertissement en fin de document. Flash Economics The isk of a steep depreciation of the dollar? The expected rise in US interest rates (Chart 1A) and the expectations of continued strong growth in the United States (Chart 1B) should normally prevent a steep depreciation of the dollar (Chart 1C). Chart 1AChart 1BUnited States: Fed Funds futures contractsUnited States: Composite ISM (index)Jan-17Apr-17Jul-17Oct-17Jan-18Apr-18 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 But we seek to determine whether there is, nevertheless, a risk of a sharp depreciation of the dollar, due to: - The inevitable deterioration in the US external deficit; - The inevitable slowdown in US growth; - The possibility of a trade conflict and retaliation between the United States and other countries (China). inevitable deterioration in the US external deficit The United States has decided to implement an expansionary fiscal policy at full employment (Charts 2A and B). This policy will inevitably worsen foreign trade (Chart 3A) since the additional demand is increasingly met by imports (Chart 3B). Chart 3AChart 3B In the past (1985-1988; 1991-1995; 2002-2011), the additional external debt resulting from the US external deficit has always led to a depreciation of the dollar (Charts 4A and B). Chart 4AChart 4B inevitable slowdown in US growth The United States is practically at full employment; the unemployment rate is low and the participation rate has stabilised (Chart 2B above). At full employment, growth inevitably slows down towards the level of potential growth (Chart 5). The growth slowdown could lead to a downward revision of the earnings outlook for US companies (Table 1) and increasing lack of confidence in US equities among nonresidents (Chart 6), which would lead to capital outflows and a weakening in the dollar. Table 1: Earnings per share (as % per year) Year S&P 2017 11.8 2018 19.6 2019 10.4 2020 10.4 Sources: Datastream, Natixis Chart 6-40-30-20-10010203040-40-30-20-1001020304006070809101112131415161718United States: Purchases of equities by non-residents (in USD bn)Sources: EPFR, Natixis But we have to bear in mind that the tax reform in the United States will increase after-tax earnings by the equivalent of 1 percentage point of GDP, and will bring back to the United States earnings held abroad of at least USD 500 billion, a significant share of which (40%?) will probably be used to finance additional share buybacks. It is therefore difficult to imagine a real correction in the US equity market. risk of a trade war between the United States and other countries (China) and financial retaliation from these countries The United States is drifting towards protectionism, especially in response to its external deficit with China (Chart 7). Chart 7-500-400-300-200-1000-500-400-300-200-10000203040506070809101112131415161718United States: Trade balance with China (in USD bn, annualised)Sources: Datastream, Census Bureau, Natixis If the taxation of products from other countries (especially from China) leads to financial retaliation i