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Tax reform and the USD

By Nick Parsons

The US Dollar has traded pretty much flat overnight and in the London morning with its index against a basket of currencies at 94.45; still in the 94.20-94.57 in which it has been stuck for the last 48 hours. Though non-farm payrolls today will doubtless lead to half an hour of very volatile trading conditions, the bigger picture for the USD will now be framed by the President’s much-heralded tax reform. This formed a central plank of his campaign pledge to “Make America Great Again” but was delayed so much that the hopes of USD bulls were consistently dashed through the first 10 months of his term of office.

From November 9th to the beginning of January, the USD Index surged from 96.6 to 103.3 on hopes for a substantial fiscal boost, faster economic growth and much tighter monetary policy. None of this materialized. The Fed is still “measured and gradual”, GDP growth will be in the 2-3% range in 2017 and tax reform hasn’t yet happened. By late September, the USD Index had slid to just 90.9. A subsequent attempt to kickstart the fiscal agenda once again raised hopes and the index is now up at 94.4. This is where the real test now comes as the Republican Party releases details of its tax cut plan. These show the 20% corporate tax cut as permanent, and claim that a family of four earning $59,000 will get a $1,182 tax cut. However, the bill also includes the repeal of an itemized deduction for medical expenses, and limits the home mortgage interest deduction.

For new home purchases, interest would be deductible only on loans up to $500,000, down from $1 million. The bottom line for currency markets is that the 429-page “Tax Cuts and Jobs Act” still has no guarantee of passing any time soon. Keep a close eye on the politicians for it is they, not the Central Bankers, who are now crucial to the US Dollar outlook.

The first Friday of the month is of course payrolls day in the United States. What tends to get overlooked is that Canada usually releases its own labour market report at the same time. Statistics Canada reported last month that Employment was essentially unchanged in September (+10,000 or +0.1%) and the unemployment rate remained at 6.2%, matching the low of October 2008. In the 12 months to September, employment rose by 320,000 (+1.8%), and the number of hours worked increased by 2.4%.

However, after two surprise rate hikes from BoC and a sharp slowdown already underway in GDP, we should note that the trends in employment are also slowing down. Overall employment grew by only 0.2% in the third quarter, slower than the 0.6% growth rate in the second quarter and the 0.5% growth rate of the first quarter of 2017.

Consensus looks for an increase of 15,000 in employment today but if there’s any disappointment, then the CAD’s gains of the last 48 hours against the USD might be difficult to sustain. For now, USD/CAD is at 1.2832 after printing 1.29 just after GDP whilst GBP/CAD is at 1.6785; down almost 4 cents from Wednesday’s high.

Wednesday may have been a European holiday but it seems that Thursday and Friday have been too in the foreign exchange market. EUR/USD still remains stuck on a 1.16 big figure whilst EUR/CAD has been on 1.49 ever since Wednesday morning in London. When a quick look at the economic calendar shows that the only numbers to be released today are Latvian industrial production, you sense that if the EUR does indeed move much, it will be due to news in North America and elsewhere than anything closer to home.

ECB Council member Ewald Nowotny gave a TV interview this morning in which he said that Euro zone inflation could be higher next year than now projected as energy prices are moving higher. In its latest projections published in September, the ECB predicted inflation at 1.2 percent next year, basing its forecast on oil prices averaging $52.6 per barrel, 16 percent below the current level. Mr Nowotny’s analysis reveals the problem at the heart of using QE and monetary policy to target inflation. Falling oil prices are in economic terms the same as a tax cut: they boost consumers’ income and firms’ input costs. But as CPI falls then the Central Bank provides further stimulus through lower rates. When oil prices rise, the exact opposite phenomenon occurs: consumers’ incomes shrink and they are then hit further with higher borrowing costs.

For the moment, the ECB hasn’t yet had to address this problem and a sharper rise in oil prices will still bring talk of higher interest rates but it’s still so far on the distant horizon that it’s not shifting the EUR.

After its dramatic plunge on Thursday, the GBP has stabilized a little in London this morning but investor sentiment has been damaged so badly by the Bank of England’s clumsily-handled 25bp rate hike that a really strong service sector PMI reading has failed to give it any lift.

We warned at the beginning of the week that a great deal of good news was already ‘in the price’ and after the BoE yesterday scaled back its forecasts for future monetary tightening, Deputy Governor Broadbent has this morning only added to the confusion. In an interview with the BBC he said, “there will be some pain and it’s one part of how monetary policy works”. Yet, despite the hit to consumers who are already struggling with falling real incomes, Mr Broadbent still suggested that, “Given our outlook currently, we anticipate we’ll need maybe a couple more rate rises to get inflation back on track, while at the same time supporting the economy”.

Perhaps he could ask some hard-hit UK retailers how they’ll be supported and if the answer is through lower import prices, then it would help if the BoE handled the rate hike process better than it did yesterday. GBP/USD is at 1.3085 after hitting a low today of 1.3041 whilst GBP/CAD is at 1.6795 having been as low as 1.6718 during the Asian session overnight.

The Aussie Dollar waited all week for some numbers on domestic economic activity and when they were finally released overnight, there was a real sense of disappointment. August had seen a very poor -0.6% m/m decline and expectations were for a decent rebound to something like +0.5% m/m in September. Instead, the Australian Bureau of Statistics reported that sales were unchanged on the month.

A detailed look at the numbers showed household goods down -0.4%, apparel down -0.7% and so-called ‘other retailing’ down -1.7%. Cafes and restaurants eked out a +0.3% m/m increase after a -1.1% tumble in August whilst department stores saw a decent 2.1% increase to help reverse the losses of the last few months.

Overall, though, it was a poor set of data and the quarterly measure of sales which feeds into the GDP estimate rose just 0.1%; the weakest since Q3 2016. Having clawed on to a US 77 cents big figure after Thursday’s international trade numbers, the AUD couldn’t even hold that level for 24 hours and this morning it’s back down at 0.7670. AUD/CAD is back testing Monday’s low of 0.9834 and if we see a decent set of Canadian employment numbers today then week’s 0.9774 low becomes the next downside target.

There was fresh news economic or political news locally on Friday but the NZD enjoyed a very good overnight session, due mostly to selling of the AUD/NZD cross after Australia’s disappointing retail sales numbers. Ten days ago, this pair reached a near-18 month peak of 1.1284 but by the start of this week had edged back on to a 1.12 big figure. At the start of the Sydney session overnight it stood at 1.1160 and immediately fell half a cent when the Aussie data were published.

As we open in London, the pair is testing the 20-day moving at 1.1108; an important technical level as it held above the 20dma for almost every single day in the month of October. It has been a long time since the NZD has been at the top of the one-day FX performance table but price action over the last few days suggests that some of the post-Election short positions in the currency are now being closed out.

There’s an RBNZ Board meeting next Thursday which will see updated forecasts for interest rates and inflation and before then on Monday it publishes the latest survey of inflation expectations. NZD/USD stands this morning in New York at 0.6915 with NZD/CAD at 0.8870.