USD: Supported by Fed rate hike expectations – RBC CM

Elsa Lignos, Research Analyst at RBC Capital Markets, explains that fiscal policy delays since the start of March, USD is up against almost every currency globally, as markets have shifted from near zero probability of a March hike in early Feb, to pricing it as a near certainty.

Key Quotes

“Assuming the Fed delivers a hike as expected, the question is what comes next? For all the talk of fiscal stimulus, it is monetary policy doing all of the work for now. That seems unlikely to change in the short-term. On Feb 9, Trump said there would be a “phenomenal” announcement on tax “over the next two or three weeks” but three weeks later nothing concrete has been presented. Ryan/Brady’s border-adjusted tax (BAT) idea faces very strong opposition in the Senate and so far Trump has sent mixed messages on the plan. Mnuchin has set the target of tax reform by the August recess but given the differences of opinion, and the work that needs to be done in parallel on healthcare, we think 2018 is a more likely prospect.”

“If monetary policy is going to do the heavy lifting, the question is how much further can it run? Our equity colleagues have been highlighting the disconnect between survey data (some hitting decade highs) and ‘hard’ data – i.e. data reflecting actual economic activity. Our US economic surprise index, which is heavier on hard data, has been hovering around zero since late January. Coupled with fiscal policy uncertainty, we see no reason for the Fed to actively talk up 2018 rate expectations (currently pricing ~4.5 hikes by end 2018). That should keep a lid on USD gains. The mains risks are (1) Congress is able to deliver tax reform sooner than expected (USD-positive) or (2) US data weaken and markets start unpricing the Fed (USD-negative).” 

“6-12 Month Outlook – Now or never for tax reform?

Looking forward, our forecasts incorporate further USD strength, but it takes time to fully play out. Corporate tax reform should be USD-positive on at least three fronts: (1) lowering headline rates is fiscal easing; in the case of corporate tax, it would raise US competitiveness and reverse the trend of corporate inversions, (2) a tax break on repatriated earnings would have a similar effect to the 2005 HIA which the evidence shows was USD-positive, despite many arguing that overseas earnings are already held in USD, and (3) a border-adjusted tax would mean considerable USD-strength (albeit unlikely to perfectly offset the impact of the tax on importers). We think markets are underpriced for (2) and (3) – where CHF and CAD should be the biggest losers respectively. Again the largest downside risk to USD comes from policy paralysis.”