US Dollar Forecasts Upgraded at Bank of America as "Repatriation Flows" Buoy the Greenback

-USD forecasts upgraded due to strong economy, repatriation flows.

-Tax cuts are lifting growth and those repatriation "are happening".

-EUR/USD seen at new lows, GBP/USD moves steadily higher in 2018.

© Nazli Sart, Adobe Stock

The US Dollar is likely to rise further against its major rivals in 2018 than previously thought, according to the latest forecasts from strategists at Bank of America Merrill Lynch, who argue the Dollar rally that begun in April will also continue for longer than even they had anticipated.

President Donald Trump's tax reforms and superior levels of economic growth in the US relative to the rest of the world are material factors in Bank of America's new forecasts, which envisage further broad gains for the Dollar including even steeper losses for the Euro-to-Dollar rate and a steady but uninspiring performance from the Pound-to-Dollar rate.

"US data is likely to continue to outpace the rest of G10 as fiscal stimulus boosts the domestic economy. Our out of consensus call on US corporate repatriation still stands. As we outline below, corporate repatriation is well underway with Q1 US balance of payments data showing that US corporates repatriated $175bn of overseas retained earnings," says Kamal Sharma, an FX strategist at Bank of America Merrill Lynch. 

In January the US Congress passed one of the largest packages of tax cuts and reforms in US history, slashing corporate taxes by nearly half and handing American households an estimated average of around $1,200 in additional disposable income per year. 

This has buoyed US retail spending and overall economic activity to an extent where economists are now forecasting US GDP growth to top 4% on an annualised basis in the second-quarter. That US upturn comes at a time when economic growth in Europe has ebbed from the high levels seen back in 2017. 

The still-widening differential between growth in the US and elsewhere has so-far helped the US Dollar index to convert what was a 4% 2018 loss as recently as mid-April into a 2.6% gain. The index, which measures the Dollar's performance against a basket of currencies, was quoted at 94.70 Tuesday.

"Trade war headlines have thrown markets into turmoil, while also obscuring the relatively positive outlook for US growth. This month we push up our core USD forecast. In particular, we have lowered our EUR-USD and raised our USD-CAD forecast profiles," says John Shin, an FX strategy colleague of Sharma's.

The Tax Cuts and Jobs Act offered US companies a one-time tax break on all foreign profits earned after 1986 and created new mechanisms through which US authorities can tax overseas profits regardless of whether they still held overseas or have already been repatriated to the United States.

Previously, companies were liable for taxes on foreign profits but did not have to pay those levies until the monies were actually transferred into the US, which gave rise to a situation where US companies were seen hoarding an estimated $2.7 trillion in profits overseas in order to avoid paying the taxes owed. 

"BEA data now confirm that repatriation is happening, and in large size. Although thus far the portion of repatriation activity originating from non-USD sources looks relatively subdued, we expect it to pick up in the months ahead. We are seeing signs of this in our LCBF data," says Sharma. 

Currency analysts spent much of 2017 debating the likely effect of the reform bill on the US Dollar given that large flows of repatriated earnings were once expected to lift the US Dollar as companies sold foreign currency earnings and bought the greenback in order to repatriate their funds.

Eventually, many analysts concluded the "repatriation flows" would provide only a limited boost to the Dollar although the Bank of America team have always insisted that the effect of the Tax Cuts and Jobs Act for the greenback would be more pronounced. They stuck by this call in their latest FX strategy note. 

"Repatriation is a theme we have been emphasizing since passage of the 2017 TCJA. We have previously estimated that $250bn-$450bn worth of reinvested earnings held in local currency (i.e. non-USD) assets abroad could return to the US as corporates pay the one-time tax on earnings held overseas. Additive to this first-order impact on the FX market are important potential second-order, USD-supportive effects," says Sharma. 

While conventional economic thinking would suggest large tax cuts should have a positive impact on the US economy, most economists panned the White House tax bill, saying it will do little to lift economic growth over the long term but that it would lead to a wider "twin deficit" that is bad for the US Dollar. "Twin deficit" describes the combined budget and current account deficits.

Many economists say this will widen because lower federal tax revenues mean a higher budget deficit, as well as a wider current account deficit because the US government will have to borrow more at the domestic and international levels to fill the gap, which then increases American liabilities to the rest of the world. But the Bank of America team see a silver lining in this particular cloud. 

"From a structural flow perspective, a re-occurring stream of repatriation activity permanently bolsters US net direct investment (DI) and improves the country’s structural flow profile by increasing the narrow basic balance (BB)," says Sharma, referring to a metric that combines the current account deficit referred to above with the balance of both direct and portfolio investments. 

The US "basic balance" returned to surplus in the first-quarter for the first time since the opening three months of 2015, rising from a deficit of -$139.9 billion at the end of 2017 to +$77 billion for the three months to the end of March. If continued this will have important positive implications for the fundamental value of the US Dollar and is a key factor in Bank of America's latest forecasts. 

The Bank of America team cut their Euro-to-Dollar rate forecasts this week, reflecting an improved outlook for the greenback, and now predict the exchange rate will fall to 1.12 by the end of September before rising only as far as 1.14 in time for year end. These are downgrades from earlier forecasts of 1.17 and 1.20 respectively. 

They predict the Pound-to-Dollar rate will rise steadily throughout the rest of 2018, to 1.32 in time for the end of September and 1.34 by year-end, although it will now not reach the peaks they had previously envisaged. The latest forecasts are downgrades from earlier projections of 1.38 in September and 1.41 by the end of December. 

The Bank of America team have been on the money with many of their calls of lates, correctly predicting a siesmic about-turn by the Euro-to-Dollar rate during the second-quarter that led them to bet against the single currency when EUR/USD was still trading at 1.23 in April, targeting a move down to 1.15.

The Pound-to-Dollar rate was quoted 0.21% higher at 1.3170 during the noon session Tuesday while the Euro-to-Dollar rate was up 0.06% at 1.1648.

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