5% Fall in Pound-to-Dollar Forecasted if Trump Finally Succeeds on Tax Cuts

If Trump finally gets his ways on taxes, expect a big jump in the US Dollar, but hurdles to such a rally remain high.

The US Dollar outperformed major G10 counterparts on Thursday, October 26 after President Donald Trump’s tax reform agenda took another major step toward the statute book and as a result analysts believe the prospect of a stronger Dollar heading into the end of 2017 is now possible.

Dollar pairs were bid sharply higher after House of Representatives lawmakers passed the Senate’s version of the 2018 budget, albeit with a narrow majority.

The budget includes provisions that will enable the US federal deficit to expand by up to $1.5 trillion, thereby facilitating unfunded tax cuts, in advance of a reform bill that is expected to be released over the coming days.

The Dollar rallied sharply on the election of Donald Trump to the White House as markets saw his proposals on tax reform as being positive. However, 2017 has seen the currency struggle as it soon became clear the President would face significant resistance in passing many policies, including those on taxes.

Big news - Budget just passed!

— Donald J. Trump (@realDonaldTrump) October 26, 2017

But, with progress being made once more, it stands that the Dollar should benefit.

“The potential to price more on the US tax front is what prompted us to adopt a tactically more positive Dollar view into year-end and our metrics suggest that pricing around this still remains too low,” says George Saravelos, a strategist at Deutsche Bank.

The US Dollar index rose 0.80% to a three month high of 94.40 in response to the bill’s passing Thursday.

The Pound-to-Dollar exchange rate dipped lower, but ultimately still stays above the key 1.31 level:

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While the Pound-to-Dollar exchange rate remains within recent ranges, Karen Jones, a technical analyst with Commerzbank warns of the potential for a fall below the 1.30 area:

“GBP/USD continues to falter at the 3rd August high at 1.3267. Directly overhead lies the recent October high and the 50% retracement at 1.3338/43. While capped here we will maintain a negative bias and target the 1.2969 2016-2017 uptrend line.”

Of course whether the exchange rate goes sub-1.30 depends on how Trump's plans proceed.

Lawmakers are thought to be aiming to have a tax reform bill drafted and passed through congress by thanksgiving, which falls on November 23.

Hopes of tax cuts making it onto the statute books have been a key pillar of support underlying US inflation and interest rate expectations through 2017.

“The market is pricing exceptionally little for US fiscal and Federal Reserve policy next year and relative US - global inflation surprises are at negative extremes,” says Saravelos.

A string of positive economic surprises from the US are likely to drive pro-Dollar sentiment forward with the budget victory coming ahead of an initial reading of US GDP for the third-quarter, due Friday, and October’s payrolls report which is due for release next week.

Consensus is for the US economy to have grown at an annualised pace of 2.6% during the quarter. Forecasters at Capital Economics see next week’s payrolls number coming in at a record +350,000 as employment picks back up in the wake of recent hurricanes.

“We turned structurally negative on the Dollar earlier in the year but argue for a tactical bounce into year-end: nearly all potential positive developments have been priced out,” Saravelos adds.

5% Rally in the Dollar... If

The verdict on how far the Dollar could go on a programme of concerted tax cuts are hard to gauge, indeed the composition of the final outcome is still almost impossible to call as it lies in the hands of politicians.

"We don't know if tax reform takes place or not in the US-our baseline projections don't include it, but we have been more optimistic than the consensus-but if it does happen, we have been arguing that profit repatriation will be very bullish for the USD," says Athanasios Vamvakidis, analyst with Bank of America Merrill Lynch Global Research, based in London.

What is for sure, is if a comprehensive range of cuts are introduced, particularly on corporate flows, the boost could be sizeable.

Vamvakidis is "very surprised that the consensus is still ignoring this issue" as BofAML estimates suggest that 40% to 60% of the money the US companies have abroad is in non-USD currencies.

"Even if half of this money is repatriated, and taking the lowest end of this range, the USD could appreciate by 5-10 percent, consistent with the move following the 2005 HIA," says Vamvakidis.

A Short-Lived Bounce?

The risks remain however that the US Dollar's bounce could be short-lived, both on disappointments surrounding the tax cut issue and future Federal Reserve policy. 

"The narrow vote in favour, as many Republicans opposed, suggests many obstacles to a comprehensive tax reform remain, and a watered-down version appears a more likely eventual outcome," warns Jan von Gerich, an analyst with Nordea Markets.

The rally could further be challenged over coming days when President Trump unveils his choice of who should head the Federal Reserve from February 2018 onward as the appointment which would be most positive for the US Dollar appears - that of John Taylor - is seen as being unlikely.

“If President Donald Trump is serious about being a “low-interest rate guy”, markets are probably right to brush off John Taylor’s chances of being nominated for Fed Chair,” says Andrew Hunter, an economist at Capital Economics.

Trump’s choice of a new Fed chair could send a powerful signal to markets. There are three candidates in the running including incumbent chair Janet Yellen, who won praise from Trump at the weekend, as well as Fed board member Jerome Powell and external economist John Taylor.

“The Fed would surely move in a more hawkish direction under John Taylor, although for that reason Trump is still more likely to nominate Jerome Powell,” says Hunter.

There are other vacancies on the Federal Open Market Committee of rate setters, which works by consensus, including the vice chair position although the market has attached significance to the choice of candidates.

Both Powell and Yellen are seen as doves, who favour only a gradual normalisation of policy, while Taylor is seen as somebody likely to be more hawkish and so favouring higher rates.

The contradictions with regards to the potential future moves in the Pound-Dollar exchange rate could best be expressed by the view that the market is liable to maintain a broadly consolidative, sideways-orientated tone.

"The bulls are certainly not in control here and the almost instant unwind of the rally just shows the number of false starts and false breaks you get with trading Cable now. The market is fast turning into a range play now between $1.3025/$1.3335 and the momentum indicators levelling off on the daily chart reflect this," says Richard Perry, a technical analyst with Hantec Markets.

"Play the range for now but there is a mild negative bias to be aware of," adds Perry.