US Dollar Rally Can Go Further Says BNP Paribas - EURUSD Seen at 1.14

The short term outlook for the Dollar is still up for debate among strategists although most agree the longer term picture is bleak.  

The Dollar has legs to extend its nascent rally into year-end and beyond, according to strategists at BNP Paribas, who say positioning is not yet as stretched as it needs to be in order for the greenback’s advance to be stymied.

Tuesday’s call from BNP comes at the tail end of a two-month period that saw the Dollar index squash a large portion of its year-to-date loss, compressing it from -11% to around -7%.

“The very negative sentiment towards the USD during the summer has improved significantly, but BNP Paribas FX Positioning Analysis suggests the market still has room to add to long USD positions,” says Daniel Katzive, North American head of FX strategy at BNP Paribas.

Expectations of tax cuts, reforms and the prospect of higher interest rates to come during the months ahead have been the main drivers of the Dollar’s Autumn renaissance.

“While the potential for a USD short squeeze has been largely exhausted, the positioning measure highlights considerable scope for markets to build long exposure if the price and news momentum remains favourable,” Katzive adds.

Market implied probabilities of further US interest rate hikes fell to rock-bottom levels during the summer as low inflation and some poor economic data left traders’ betting the Federal Reserve would sit on hold for the rest of 2017.

“With the Fed having continued to downplay soft inflation readings at its November meeting, our Economics team now expects the FOMC to deliver a 25bp rate hike in December, and to follow up with three additional hikes next year,” says Katzive.

Other factors behind the Dollar’s ascendency are predominantly developments in Washington. The Trump administration struck a deal with the opposition to avert a government shutdown toward year-end and won some Republican support for its signature policy of tax reform, encouraging hopes the White House may yet be able to implement its agenda.

“We remain of the view that tax reform is not yet priced into the USD. Our economics team sees a 65% chance of tax reform being passed by mid-2018, and as progress continues on this, the USD should remain supported,” Katzive says.

EUR/USD shown at weekly intervals. Captures 2017 rise and fall.

Katzive and his team have forecast the Euro-to-Dollar rate to fall to 1.1400 during the weeks ahead, although the BNP Paribas year-end forecast is for EUR/USD to sit around 1.1500.

That said, the longer term outlook for the Dollar remains bleak according to the BNP Paribas team, which is something that most strategists tend to agree on.

“We remain bearish on the USD in the medium-to-longer term, but would wait until long USD positioning has become a bit extended and the chance of a tax reform is more fully priced in before considering entering new shorts,” says Katzive.

The Euro-to-Dollar rate was quoted 0.39% lower at 1.1566 Tuesday as the greenback continued to advance on its G10 rivals. The Pound-to-Dollar rate was marked 0.32% lower at 1.3129.

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Morgan Stanley Goes Bearish as Commerzbank Pans Tax-plan

The Dollar rally could be nearing its end, says Morgan Stanley, as much of the positive news around tax reform has already been priced-in and markets have ignored risks to the reform bill’s passage through Washington.

Strategists at the American bank are forecasting a return of the US Dollar bear as current positioning provides scope for a violent correction if drafts of the tax legislation gets bogged down in the swamp of Washington politics.

Meanwhile, analysts at Germany’s Commerzbank are sceptical of whether the bill can live up to the market's lofty expectations, even if it is approved by a sufficient number of lawmakers in Washington.

“We see USD nearing the end of its rally. Our positioning tracker shows USD bullish sentiment at extreme levels last seen in December 2016, suggesting there may be a correction,” says Gek Teng Khoo, a strategist at Morgan Stanley.

Dollar strength was an enduring theme throughout October as traders responded to the Federal Reserve signalling it will likely raise US interest rates again at its December meeting.

President Donald Trump appearing to make headway toward passing a signature tax reform bill was also a key driver of price action that saw the Dollar index whittle an 11% 2017 loss down to just 7%.

US Dollar Index shown at weekly intervals. Source: Netdania Markets.

“Near-term political risks relating to tax reform also keep us bearish on USD as much of the positive news on tax reform has been priced in,” says Khoo.

Many are betting the tax bill will boost US economic growth, lift inflation expectations and raise market forecasts for US interest rates. But increasing numbers are now growing sceptical of whether the current bill has any chance of ever becoming law.

“To prevent a massive rise in new debt the plan projects to abolish many exemptions. But this is exactly where the political fighting starts,” says Ulrich Leuchtmann, an analyst at Commerzbank. “At the end of the fighting we may still see a significant tax reform, just not the one currently planned.”

The knock-on effect that higher growth can have on inflation expectations is the primary pass-through seen accruing to the Dollar from any tax cuts.

For the greenback, President Trump’s plan to reform the tax treatment of American companies’ offshore profits was always the jewel in the crown, given that estimates place America Inc’s offshore wealth at some $2.5 trillion.

“The main USD positive argument of the tax reform has been watered down in a significant way: the large “repatriation flows” that in the view of many market observers would have caused the dollar to appreciate massively will hardly materialise,” says Leuchtmann.

The rub for Dollar bulls is that any tax holiday may ultimately be implemented using a process called “deemed repatriation”, which would minimise the Dollar value of monies that are actually transferred back to the US.

Deemed repatriations would enable American companies to pay a one-time special tax bill to have offshore monies deemed as repatriated and therefore, legitimised in the eyes of American tax authorities. The bulk of those monies need not actually be repatriated.

“Of course the companies affected have to get some money to the US to pay their tax bills,” Leuchtmann concedes. “But even the Tax Foundation estimates this amount to be only USD 223 billion – stretched over eight years. Peanuts for the FX market.”

Republicans are aiming to have the draft tax reform bill voted through congress by Thanksgiving, which falls on November 23.

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