Buy the Pound, Sell the Dollar: Strategists on Fading the Trump Tax Cut Bounce in USD

Strategists recommend fading the US Dollar bounce as a trading strategy as tax cuts are themselves likely to become the subject of cuts.

The US Dollar has bounced its way into the Thursday session, aided by the Trump administration’s unveiling of plans for America’s largest tax cut in three decades, although the boost could fade fast as horse trading toward a final deal commences in Washington.

Strategists see the proposed measures themselves being subjected to cuts during the coming weeks as Republican advocates for the competing ideals of fiscal responsibility and low-tax-small-government will now sink their respective teeth into the administration’s signature bill.

Traders should fade the Dollar bounce over the coming days, according to one strategist, particularly against other currencies where the domestic story remains bright.  

“Fading this is our preferred tactic, especially versus currencies where the domestic story remains constructive. In the G10 FX space, buying GBP/USD on dips looks attractive,” advocates Viraj Patel at ING Group.

The Pound-to-Dollar rate saw a strong bounce during the morning session in London after a joint press conference between Brexit secretary David Davis and EU negotiator Michel Barnier showed broad progress toward settling some of the key issues in divorce negotiations. 

Above: The Pound-to-Dollar exchange rate falls in the hours following new details on the US administration's plans to cut taxes.

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“The developments are clearly positive for the US dollar in the near-term. After the heavy sell-off in recent months, there is a risk that the corrective rebound could extend more than expected as short positions are lightened,” says Lee Hardman, a currency analyst at Japan’s MUFG. “However, we remain sceptical over the sustainability of the rebound.”

The president and Republican Party have proposed to lower the US corporate tax rate to 20%, down from a statutory rate of 39.1% - which includes the federal rate of 35%.

“The unified tax proposals released today, before President Donald Trump’s speech, are almost identical to the House Republicans’ “better way” plan released ahead of last year’s election, albeit with the infamous border adjustment tax stripped out,” says Paul Ashworth, chief North American economist at Capital Economics.

Small businesses will see their tax rate fall to 25% under the plan, while the top rate of income tax for individuals will also be cut.

“The bulk of tax savings will go to high income earners, but that is hard to avoid when the top 10% account for 70% of all income tax revenue,” says Ashworth.

In addition, there are provisions for major changes to America’s tax treatment of offshore profits, which also allow for a one-time tax break on the repatriation of corporate profits currently held overseas.

“The Federal government would cease to tax US firms on profits earned abroad. The downside for firms is that they would be forced to pay tax on all accumulated profits currently held overseas,” says Ashworth.

Close to $3 trillion of profits are held offshore by American companies, some $150 billion of which is likely to be held in foreign currency denominated assets, according to analysts.

“The proposals were vague on both. But assuming the rate is 10% (taken from the earlier Trump plan) and firms can take five years, it would be equivalent to around $50bn a year,” Ashworth adds.

The Dollar might draw periodic bids from the repatriation narrative over the coming months so long as it remains on the table as something that is actually likely to happen. But the broader economic impact of the tax cuts and rule changes is far from certain.

US Dollar Index, 2017. Source: Netdania

“The evidence from other countries that have lowered their corporate tax rates is that it does not lead to any significant pick-up in the growth of investment, productivity, employment or economic activity. Instead, lower corporate taxes tend to boost dividend payments,” says Ashworth.

The Trump/Republican proposals come at a time when the US economy has shown signs of regaining momentum after a first half lull and while the Federal Reserve continues to chart a course toward higher rates.

“On balance, we still believe it is more likely that the Fed will slow the pace of rate hikes rather than speed up in the year ahead,” says MUFG's Hardman.

Markets bid the US Dollar higher against the G10 basket overnight and early into the London session Thursday. But scepticism over whether the proposals will make it through the Washington machine intact, their ultimate economic impact and the durability of the Dollar’s bounce is growing. Meanwhile, the Dollar has already shown signs of faltering.

“Our message for investors is not to get carried away; for all the hype over tax reforms this week, the release hasn’t added to what we already knew,” says ING's Patel.

The details unveiled on Wednesday do not give markets enough information to accurately assess the impact on the Federal budget deficit, the debt pile or the broader economy.

Moreover, the focus of the measures has overwhelmingly been on tax cuts and not the more-valuable tax reform that was promised, Patel says.