Tax cuts, higher interest rates, faster GDP growth and renewed dovishness from the world's other central banks all add up to a stronger US Dollar toward year-end.
The US Dollar should remain firm going into year-end, according to strategists at Commonwealth Bank of Australia, as multiple factors conspire to boost the greenback.
Eagerly anticipated tax cuts and reforms are among the key drivers behind expectations of Dollar strength but are not the sole forces likely to propel the US currency to further gains.
“The USD maintains a bias to remain firm into year-end while the U.S. Congress debate the details of a maximum $1.5 trillion fiscal tax package,” says Elias Haddad, a senior currency strategist at Commonwealth Bank of Australia.
President Donald Trump’s signature tax bill, which combines large tax cuts with some minor changes to tax rules aimed at simplifying the overall tax system, is slowly but surely making its way through Washington.
“While we don’t know final details of the tax package, cuts to the U.S. company tax rate are supportive for the USD,” says Haddad. “We are lifting our USD forecasts for four main reasons.”
Haddad cites the prospect of tax cuts, faster GDP growth, forecasts for a higher federal funds rate and renewed divergence between the monetary policies of the Federal Reserve and the European Central Bank as factors likely to support the Dollar over the coming weeks.
“We are experiencing the re-emergence of large scale monetary policy divergence between the U.S and the rest of the world,” Haddad notes. “Our new forecast of a higher Fed funds rate, contrasts with recent fresh communication from a number of global central banks.”
Both the ECB and the Bank of England managed to pull off relatively dovish monetary policy moves in late October and in November, leading both the Euro and Sterling to decline after announcements of QE tapering and an interest rate hike respectively.
“On Monday 6th November, we lifted our Fed funds forecasts to pencil in an additional 25bpts lift in the Fed funds tightening cycle to 2.00%, with the risk of a further 25bpts rise to 2.25% in September 2018,” adds Haddad.
Both the Reserve Bank of Australia and the Reserve Bank of New Zealand remain on a dovish footing, meaning they are likely to keep interest rates at their current low levels and continue to sound cautious when communicating the outlook for their respective economic domains.
“We are likely to see some USD buying as foreign capital flows into the U.S. economy in response to cuts in the U.S. company tax rate,” says Haddad. “We anticipate a lift in equity capital inflows into the U.S. economy, from its current rate of US$100bn p.a.”
All of this points toward US Dollar strength in the coming weeks, particularly when the greenback is stood next to the Euro, Sterling, the Kiwi Dollar and the Australian Dollar. Haddad says Commonwealth Bank economists see the US tax package adding up to 0.3% on to US GDP in 2018 and 2019.
However, the rub for US Dollar bulls is that the tax bill must secure safe passage through Washington before it eventually passes into law. This means lawmakers voting by a majority to approve the bill in both the House of Representatives and the Senate.
“We do not yet know the final details of the tax package, and further changes to the tax package currently proposed, are inevitable,” warns Haddad.
Lawmakers in both houses have a litany of concerns about aspects of the bill and are currently locked in a review process that could see it amended beyond all recognition.
Any eventual boost to the US economy and the Dollar will depend on the extent to which it is able to pass through both houses unamended.
This is an important process for markets because each of the houses has the power, and seemingly the willingness, to sink legislation coming from President Trump’s desk.
It was opposition from within the republican party that led to the failure of the Trump administration’s push to repeal and replace the Affordable Care Act (Obamacare).
This effort failed despite “repeal and replace” being a signature policy of the entire republican establishment throughout the last two elections.
The existing Trump plan cuts the corporate tax rate to 20%, down from 35%, and doubles the threshold at which high earners become liable for the top rate of tax. If the bill passes, high earners will only pay the top 39.6% rate on earnings over $1 million ($500,000 currently).
Measures geared toward lower earners are said to be worth an estimated $1,200 for every family of four earning the median household income of $59,000.
Current proposals for changes to the tax treatment of foreign profits for US companies also offer scope to support the Dollar. A special low-double-digit tax rate on the repatriation of foreign profits could see more than $300 billion of foreign assets repatriated.
Haddad and the Commonwealth Bank team now forecast the Euro-to-Dollar rate to sit around 1.1700 by year end, down from their 1.2200 projection just a few weeks ago.
Meanwhile, the Pound-to-Dollar rate is seen closing the year at 1.3300, down from CBA’s earlier forecast of 1.3860.
The AUD/USD rate is seen finishing 2017 at 0.7800, down from 0.8000 just a few weeks ago.
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