Euro-to-Dollar Rate Heading Back to 1.10 as US Tax Reform Tipped to Give USD a Boost: Bank of America

“While we expect near-term upside for the USD, we expect much of that to reverse in later 2018 and into 2019”- John Sin, Bank of America Merrill Lynch

The Euro-to-Dollar exchange rate could be heading all the way down to 1.10 during the coming months, according to strategists, as the Trump administration moves closer to implementing its tax reform policy and markets are forced to take full account of the measures.

Persistent doubts over whether the bill will make it through the Washington gauntlet have seen traders reluctant to price in any meaningful uplift to US growth stemming from the measures but the incentive, and pressure, for lawmakers to pass the reforms is underestimated by the market.

“We see potential for better growth, higher rates, and a near-term stronger USD as a result, especially as tax cuts could be front-loaded in light of the upcoming 2018 mid-term elections,” says John Sin, a strategist at Bank of America Merrill Lynch.

The original version of the reform bill cuts America’s corporate tax rate to 20%, down from 35%, and doubles the threshold at which high earners become liable for the top rate of tax.

“Markets do not appear to have full tax reform priced in at this point. But the political imperatives to pass something become more urgent as midterm elections grow closer,” adds Sin.

Above: EUR/USD shown at hourly intervals.

High earners will see the threshold at which they become liable for the top 39.6% rate of tax raised from $500,000 to $1 million. Meanwhile, the average family of four earning the median income of $59,000 is set to save around $1,200 per year following changes to the minimum threshold and the tax credit system.

“The US economy is, by many measures, already near full employment. Tax reform would likely result in a combination of near-term stimulus and increased deficits that would imply in higher rates and a higher USD as well,” says Sin.

A special low-double-digit tax rate on the repatriation of foreign profits could see American corporates bring more than $2 trillion of foreign assets back to the states - something which might be positive for the Dollar. Overall, the cost of the tax cut program is seen adding $1.5 trillion to the deficit during the next decade.

“A considerable chunk of that cash is likely to be in foreign exchange, as much as 40% by our estimation as well as our own internal survey of corporations. This means that repatriation would imply sizable USD buying as a result,” says Sin.

Above: EUR/USD shown at daily intervals. Captures 2017 trading.

While some alterations to the bill are possible, for the Republican Party, the importance of passing the tax-reforms and having measures implemented as soon as possible couldn’t be overstated.

“The political imperatives to pass something become more urgent as midterm elections grow closer, especially given the single-party gridlock that has transpired since the 2016 election that ushered Republican control of both the White House and Congress,” Sin writes, in a note Tuesday.

A case of ‘gridlock’ in point is the republican failure to repeal the Affordable Care Act, after having made opposition to ‘Obamacare’ the party’s raison d'etre in the years since 2012.

“We target 1Q USD strength, as we feel that the FX impact of repatriation as well as the macro results of tax reform would be priced in quickly,” says Sin.

Republicans campaigned in 2016 on a “repeal and replace” platform only to abandon the policy once returned to Washington so some within the party could be concerned about a possible bloodbath at the November 2018 mid-term elections.

“While we expect near-term upside for the USD, we expect much of that to reverse in later 2018 and into 2019,” Sin adds. “Still, the USD would be at relatively elevated levels compared to the past few years.”

Bank of America forecasts put the Euro-to-Dollar rate down at 1.10 by the end of the first-quarter 2018, although the pair is still expected to close the 2018 year around 1.19, implying a substantial recovery is likely in the second half.

Above: EUR/USD at weekly intervals. Captures 2017 year to date and earlier trading.

“We expect that macro focus could switch away as 2018 progresses from the US to overseas central banks, especially the ECB. Our European Economics team expects the ECB to start normalizing policy rates,” adds Sin.

Sin’s call for EUR/USD to drop to 1.10 is almost contrarian call at present, given the majority of analysts are forecasting another year of strong gains for the Euro, although he is not alone.

“The two year real rate spread in two years (2y2y) between USD and EUR real rates is again almost at the widest level of the last 3-years,” says Dr Florian Weber, a strategist at J. Safra Sarasin. “However, the EUR/USD exchange rate is trading close to the highest level of the same period.”

Much has been made in recent months of the structural underweight position, in Eurozone assets, held by American money managers. Outflows from Europe in the wake of the debt crisis and the slow but steady return of flows back into the currency bloc could be driving the divergence.

“Either the real rate spread falls or the exchange rate needs to correct. We expect a gradual weakening of the euro against the US-Dollar in 1H2018 to $1.12,” adds Weber.

Rather than focusing on interest rate differentials or the macroeconomic impact of President Donald Trump’s tax reforms across the Atlantic, other strategists are flagging a growing gulf between the Euro’s market price and its “fundamental value” derived from econometric models.

“EUR-USD remains undervalued and should approach its fair-value level of 1.25 by the end of 2018, supported by the ECB’s QE tapering and a return of portfolio flows in the euro area,” says Erik F. Nielsen, chief economist at UniCredit Bank.

Nielsen forecasts an acceleration of Eurozone economic growth in 2018 that should see the economy expand by around 2.3%, supporting the ECB’s move to wind down its quantitative easing program, although the persistence of low inflation is likely to mean that interest rates remain low well into 2018, if not beyond.

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