USD: Relaxed on tax? - Rabobank

US stock market hit yet another record high yesterday, propelled by optimism about forthcoming tax reform, while the tone of the USD by comparison was soggy, according to Jane Foley, Analyst at Rabobank. 

Key Quotes

“The simplest explanation about the lack of impetus in the USD is that the news of impending US tax cuts is already priced in.  However, there are a number of other factors worth considering when evaluating the outlook for the USD.” 

“Without doubt the “will they, won’t they” debate about US fiscal reform has been a significant influence on the greenback over the past year. The value of the USD surged on Trump’s election victory last November and subsequently spent most of the year giving back these gains as the President’s energy was dominated by a failure to repeal Obamacare and by a series of crises, many of his own making.  In September, the value of the USD underwent a revival as Republicans appeared to pull out the stops to push their programme of tax reform.  The value of the DXY dollar index, however, is currently languishing below its late October high, suggesting that the issues of tax reform has lost its fizz.” 

“A year ago, there was plenty of speculation that tax reform, and more specifically cut in the tax rate on the overseas profits of US companies, would trigger a surge in demand for the USD as these earnings were repatriated. More recently the market has come around to the view that as much as 90% of these profits are already held in USDs, meaning that there would be next to no impact from these changes.  Analysis that refers to the tax holiday for overseas earnings that was offered by Bush in 2004 inevitable stumbles upon the fact that rise in the value of the USD through 2005 could have been caused by the sharp policy tightening announced by the Fed that year (the Fed hiked rates over 400 bps between mid-2004 and mid-2006).”

“Although the Fed is currently in hiking mode, there is plenty of scepticism in the market as to how far and fast the Fed can raise rates.  Also, the Fed’s policy tightening precedent could also be followed by an increasing number of G10 central banks in 2018 meaning that USD bulls must factor in the impact of smaller than expected interest rate differentials.”

“At the end of this week the Fed’s favoured inflation measure, the PCE deflation is due to be released. This will follow the release of weaker than expected US CPI inflation last week.  In November the Fed Chair Yellen stated that the sluggish nature of US inflation this year was ‘mysterious’.  However, the weakness of wage inflation and the tendency for workers to be paid a diminishing slice of national income would appear to offer a part explanation for the subdued nature of CPI inflation throughout much of the G10.”

“In several G10 economies, weak wage inflation is coinciding with a period of high household debt/income ratios and low savings rates.  For the marginal household higher interest rates could therefore be problematic.   Although the US may not be the most vulnerable G10 economy, the US recovery and the Fed’s tightening programme is more advanced.  It remains our central view that the Fed will retain a very cautious attitude towards policy tightening and that it will only hike rates only twice next year.” 

“While we are optimistic regarding the prospects for the USD vs. a range of global currencies. However, without a significant surge in US inflation the USD could be bogged down by soggy bond yields meaning there could be only wavering support for the greenback on some crosses.  For EUR/USD we retain a target of 1.20 for 2018, though since the market is already long of EURs we do see risk that significant gains above this level could be difficult to achieve.”