USD Blasé To Tax-Reform Progress

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.

The movements in the forex market this past week confirmed how important tax reform is to the American people, Congress and the financial market. If done right it will be President Trump’s greatest achievement. The only problem is that not everyone believes that it will provide the U.S. economy with a sustainable long-term boost and, more importantly, the vast differences between the versions proposed by the House and Senate means a showdown in Washington. Throughout the past week, we saw how setbacks in tax reform has hurt the dollar and in the coming week, we need to see progress rather than regression for the U.S. dollar to resume its rise. Although tax-reform developments will dominate the headlines, the dollar’s performance in the week ahead will be affected by 3 distinct factors – politics, economics and monetary policy. There’s no doubt that politics will be the primary driver but with 6 Federal Reserve presidents speaking, the prospect of rate hikes could also affect how the greenback trades. Retail sales and consumer prices are also scheduled for release and investors will be eager to see if last month’s sharp increase in jobs translated into more spending. While we believe that rate-hike talk could lift the greenback, lower gas prices and zero wage growth in October along with the drop in consumer sentiment means spending may be restrained. So on balance, we expect a mildly positive boost from Fed speak and U.S. data. As for tax reform, the biggest concern is that many Americans feel it is insufficient and benefits the wealthy. For the U.S. dollar, the only thing that matters are progress or setbacks. There are major differences in both bills including a delay in the corporate tax cut, 4 vs. 7 tax brackets, the mortgage deduction cap and the handling of state and local tax deductions. But after Democrats swept state races, House and Senate Republicans are motivated to get this one major legislative win before the midterms. The House is scheduled to vote next week, which could be a nonevent considering that Senate approval is what really matters. The Senate Finance Committee will begin marking up its tax plan in the week ahead and headlines related to this process could have a significant impact on the dollar. At the end of the day, we expect the House to accept many of the Senate’s proposals but Republicans can only afford to lose 2 votes in the Senate if they want a majority as it’s unlikely that any Democrats will vote for the plan. It’s still a long road ahead that will be marked by both setbacks and progress but at the end of the day, we believe that tax reform will be achieved and when that happens, we will see a nice near-term rally in the greenback. Meanwhile the EUR/USD is primed for a breakout. Having traded in a narrow 1.5 cent range over the past 2 weeks, the currency pair drifted to the top of the range on Friday on the back of softer U.S. data. There were very few Eurozone economic reports released over the past week but EZ retail sales, producer prices, German factory orders, the trade balance and current account balance were all better than expected. The only report that missed expectations was German industrial production, which tanked in September. These latest economic reports show that the Eurozone economy is still performing quite well and comments from European Central Bank officials have been less pessimistic. ECB member Constancio said no decision has been made about buying more corporate bonds and member Lane noted that the bar for anther QE extension is higher. While the ECB is not ready to raise interest rates anytime soon, there are also no plans to return to more stimulus. We’ll get a much better look at how the Eurozone economy is doing in the coming week with third-quarter German and Eurozone GDP numbers scheduled for release along with the ZEW survey and CPI reports. What the market will be focusing on however is ECB President Draghi’s speech on Tuesday. He will be speaking on a panel with Yellen, Kuroda and Carney. While EUR/USD enjoyed a recovery this week, there’s still significant resistance between 1.1680 and 1.1725. It needs to rise above 1.1750 in order to shake off the negative bias. If Draghi takes the opportunity to remind the market that rate hikes are a long way off, EUR/USD could find itself back below 1.16 quickly. Sterling turned out to be the best-performing currency this past week thanks to a beginning-of-the-week and end-of-week rally. There was actually very little in the way of U.K. data except for Friday when the currency was propelled higher by stronger industrial production and trade balance. There was also no progress on Brexit talks though Prime Minister May has grown increasingly conciliatory with the talks that she could be willing to pay the EU the entire Brexit bill and possibly even more to secure a better trade deal. The EU on the other hand hasn’t been very cooperative and so Brexit developments still need to be watched carefully going forward. Next week will be a busy one for sterling with labor, inflation and retail sales reports scheduled for release along with speeches by a number of Bank of England officials including Governor Carney. Our bias is for slightly weaker U.K. data so GBP/USD could sink back down below 1.31. All 3 of the commodity currencies traded higher this week with the Canadian dollar leading the gains. From the sharp rise in the yield spread to the uptick in oil prices (crude hit its highest level in 2 years) and the stronger-than-expected IVEY PMI report, all recent market developments supported the rally. Investors were even able to overlook comments from Bank of Canada Governor Poloz who took the opportunity to point to the challenges facing Canada’s economy as reasons why policy needs to remain cautious. Looking ahead, the main events on Canada’s calendar will be BoC Wilkin’s speech on Wednesday followed by Friday’s consumer price report. Having fallen sharply since the beginning of the month, we would not be surprised by a relief rally in USD/CAD. Both the Reserve Bank of Australia and Reserve Bank of New Zealand left interest rates unchanged this week and both currencies failed to sustain their initial gains. The RBA left its GDP forecast unchanged as it thinks that low rates continue to support growth. However with inflation likely to remain low for some time (RBA lowered its 2019 CPI forecast), the central bank maintained a firmly neutral policy stance. It still sees house prices rising in parts of the country with solid employment growth, which suggests strength for the upcoming October labor-market report. On a technical basis, AUD/USD has been trading in a very tight range. If it breaks above .7730, the next stop should be 78 cents. However if it breaks its 4-month low of .7625 (that’s less than 40 pips away from where AUD/USD settled), we could see a deeper slide down to 75 cents. Although the New Zealand dollar has not responded appropriately, the Reserve Bank of New Zealand turned less dovish. The bank brought forward the time when it thinks inflation will reach its target by 3 quarters to Q2 of 2018 and its forecast for the next rate hike by one quarter to Q2 of 2019. RBNZ still sees inflation slowing in the first quarter of next year but believes that a lower currency will help to boost prices. In the press conference, RBNZ’s Spencer was generally optimistic confirming that the central bank is less dovish now than in September. While NZD/USD looks weak on a technical basis, we believe this positive bias should pave the way for a recovery in the currency. Producer prices and the October manufacturing PMI report are the main releases to watch next week.

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