US Dollar at Risk of Tax-tantrum as Senate Republicans Loom Over Reform Bill

US Treasury yields are in retreat, German Bunds have steadied, Senate Republicans are meddling and so a tax-tantrum could be in store for the USD. 

The Dollar weakened in London Wednesday as doubts over the Trump administration's tax-reform plan grew, reinforcing scepticism over whether it will ever be able to deliver a boost to US inflation and interest rate expectations.

Amendments to President Donald Trump’s tax bill were always likely as it makes its way through congress, but The Washington Post reported Tuesday that Senate Republicans are now considering amendments that would delay corporate tax cuts by more than a year.

Subsequent reports from The Hill confirm a senate push for the delay and expand on simultaneous claims that some republicans intend to pursue a repeal of laws that allow Americans to deduct state and local taxes from their federal tax bills.

“It remains very clear that we are a long way from getting anywhere close to a tax bill and currencies where positioning is extreme is where you could see the greatest disappointment as expectations of a deal continue to recede,” says Derek Halpenny, European head of global markets research at MUFG.

The delays and repeals are said to be part of an effort to help reduce the budgetary cost of the tax cuts but, if they don’t derail the tax plan entirely, robbing Peter to pay Paul could risk undermining the very object of the exercise.

“Democrats continue to push with the line that the plan only helps the rich and that a large portion of middle-income earners will actually end up paying more tax than under current tax legislation. And we have yet to even see the bill from the Senate,” Halpenny notes.

USD/JPY could see the most violent reaction to a tax-disappointment, given the extreme levels of bearishness that have weighed on the Yen of late, a phenomenon exacerbated by the Bank of Japan having renewed its commitment to keeping bond yields low through quantitative easing.

Chart showing USD/JPY at daily intervals. Captures Dollar strength and Yen weakness.

“The Republican Party has been comfortable ignoring the national polling,” Halpenny notes, before flagging a continued decline in President Donald Trump’s nationwide approval rating. “However, if polling begins to show more consistently a drop in popularity amongst Trump’s own support-base, Republicans are likely to become less fearful of opposing policy initiatives from the White House.”

Low nationwide approval ratings for President Trump are not new, but some pollsters are now claiming to have observed a fall in support among the core grassroots base that propelled the 45th president into the White House in November’s election.

“This could turn out to be very significant,” Halpenny comments, noting an ongoing investigation into alleged collusion between President Donald Trump’s campaign team and “Russia”. “Falling grassroot support would leave President Trump and/or his election campaign team more vulnerable.”

The growing threat of a tax-tantrum comes at a pivotal time for the Dollar. Since the earlier greenback sell-off came to a halt and the ECB clarified its position on its withdrawal of stimulus, the bottom has fallen out of the Euro’s rally and the traditional relationship between currency prices and interest rate differentials has reasserted itself.

EUR/USD shown at 4 hour intervals. Captures peak of Euro rally and subsequent decline.

“In calm, low volatility trading conditions this is no surprise," says Halpenny. "The question is whether the spreads can continue widening in favour of the dollar.”

A renewal of vows between FX and yields is good for some as it makes markets that bit easier to interpret, but it’s less good for the Dollar as a damp squib tax reform could mean the current differential between US Treasuries and German Bunds becomes more difficult to sustain.

“We have now observed seven consecutive days of net outflows from the US dollar,” says Samarjit Shankar, head of iFlow and quantitative strategies at BNY Mellon.

Last week saw the first bout of Dollar selling since late July, according to Shankar, marking a break in a largely uninterrupted three-month buying spree.

“It remains to be seen if the fresh USD outflows we have observed via iFlow are sustained and whether they begin to translate into a retreat of the greenback as it catches up to narrower yield differentials,” Shankar adds.

Recent price action around the Dollar also coincides with a retreat of US Treasury yields, which have pulled back from 2.47% a fortnight ago, to sit around 2.31% Wednesday.

German bund yields have also fallen, minimising the compression of yield differential, although it could be said there is only limited scope for a continued offsetting-move-lower in Bund yields given much of the bad news around the European Central Bank seems to be out and on the table.

GBP/USD was buoyued in 2017 by Dollar weakness and changes in BoE monetary policy. 

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