Policy Mix Underlines Positive Fundamental Backdrop for the Dollar

The prospects that the Republican-controlled legislative branch
would find a compromise to tax cuts were enhanced when a few senators appeared
to capitulate without much to show for it may have helped lift US stocks and
dollar ahead of the weekend. 
Each chamber must now approve the reconciliation measure, which
does not look particularly like either the House or Senate bills, though the
regressive thrust was maintained. 
Passage will be relatively
easy in the former, but it will be a close call in the Senate. 
 There are a few Republican Senators
that do not face re-election, like McCain and Flake from Arizona and are not
subject to party retaliation.  Still, despite “maverick”
rhetoric, and others professing concern about the resulting deficit, the odds
of passage have improved.
At the same time, the
Federal Reserve raised interest rates and the median Fed forecast was for three
more hikes next year. 
combination of expanding fiscal policy and tighter monetary policy is associated with an appreciating currency. 
As we have pointed out before, the two “textbook” examples are the
Reagan-Volcker mix of the early 1980s and the terms of the reunification of
Germany in the early 1990s.   A year ago, many investors were led to
believe the fiscal expansion was going to be
delivered in 2017.
The failure to deliver this
stimulus in this year and recovery of the anxiety over European politics since
the Dutch and French elections in the spring are reasonable factors behind the
poor dollar performance and that the euro was the strongest of the major
currencies this year. 
It appears that early 2018, attention will turn to the other leg of the fiscal
stimulus–an infrastructure initiative.  A public-private partnership is
consistent with the signals from the White House, which could see around $200
bln from the federal government, though it may be
cannibalized from some current programs.
We agree with those that do not expect the tax adjustment on overseas
profits by American companies to boost the dollar directly or fuel much
direct impact on the dollar is limited by
the fact that most of the estimated $2 trillion overbooked
abroad is kept in dollar-based
The jaundiced eye toward the
prospect of an investment spree is derived
from experience. 
 Research of the 2004 tax holiday,
for example, cited by the Wall Street Journal, found that for every dollar
repatriated, 79 cents went for repurchasing shares, and another 15 cents went to dividends.  The research found no
increase in domestic dividends.  Also, as reported ahead of the weekend,
US industry is operating at a little more than 77% of capacity.  The last
cyclical expansion saw capacity utilization rates exceed 80%.
There may be an indirect impact on the dollar from the changed
tax regime for internationally book profits.
  It may come through the current account narrowing as
investment income is repatriated. 
Traditional models of valuation in the foreign exchange market emphasize the
basic balance as a key driver of movement in the foreign exchange market.
The recent string of
economic data suggests that the synchronized economic expansion in the US,
Europe, and Japan is strengthening as the year winds down.
  The stronger than expected US
retail sales report points to a strong personal consumption report this week
and prompted economists to revise up estimates for Q4 US GDP.  The Atlanta
Fed sees it tracking 3.3%, while the New York Fed sees 4.0%.  The NY Fed
also projects Q1 18 growth of a little more than 3%.
The flash December PMI for
the eurozone suggests another quarter of strong growth. 
 The expansion is broadening, and recent high frequency data shows regional
laggards, like France and Italy, are also participating.  It may not be a
coincidence that as the economy has strengthened, Macron’s public support has
risen.  Italian elections look likely to be held in the first part of
March next year, and, perhaps the better economic performance will ease the
attraction of extreme policies.
Sweden’s Riksbank meets in the
week ahead.
upside surprise in the November CPI and strong growth will discourage it from
extending its asset purchase program.  On a trade-weighted basis, the
krona is largely flat on the year, which is helping keep financial conditions
easy.  The euro is trading near seven-year highs against the krona. 
If the currency weakness persists, it may give the central bank the latitude to
consider a rate hike around the middle of next year. 

The immediate political
focus in Europe is on the German attempt to put together a new government three
months after the election

In Germany’s way, there will be exploratory talks first.  These can talk
several weeks.  Merkel does not want to lead a minority government. 
The SPD does not want to lose its identity in another coalition
government.  Both blocs do not want to return to the polls.  In the
September election, both saw their public
support fall to post-WWII lows.

A type of arrangement where the SPD and CDU/CSU agree on several broad programs
and then fight for the rest of the agenda in the Bundestag seems like a
minority government but may be the basis of a compromise.
It allows the SPD to still be the
main opposition party (rather than the AfD) and draw the parliamentary
privileges associated with it.

Catalonia goes to the polls
next weekend.
polls suggest a tight race between the secessionists and federalists. 
However, many secessionists have moderated their message.  Still,
regardless of the results, whatever political uncertainty that lingers for a
bit, it is unlikely to return to levels seen in earlier in Q4. 
Before the weekend, Fitch
upgraded Portugal’s sovereign rating to BBB from BB+. 
 It is the first mover, as S&P
sees Portugal as a BBB- credit and Moody’s is
a step below at Ba1.   Investors may be ahead of the rating
agencies as Portugal has outperformed.  Consider that over the past three
months, Portugal’s benchmark 10-year bond yield has fallen 99 bp compared with
a 13 bp decline in Spain’s comparable yields and a 26 bp decline in
The UK government’s belated
success in getting the EU’s approval to start talks about the post-exit was tarnished by the loss of having the last
word on Brexit.
a narrow vote, Parliament secured the right to grant final approval. 
Another confrontation and possible defeat could be avoided in the week ahead if
the specific date of 31 March 2019 can be removed from withdrawal
Given that Q1 18 will be
spent discussing the transition period, a hard date may make that period more
  It is in
the EU’s interest to argue for a standstill agreement; this is one that keeps the UK firmly in the EU’s rules and
regulations, while the UK would be technically out of the EU.   It
also seems widely recognized that the Irish border issue has not been resolved
in any meaningful way, implying that it could emerge again as a formidable challenge.
The US two-year premium over
the UK appears to be the widest in at least a quarter century and sterling its
flirting with a downtrend line drawn off the 2014 and 2016 highs. 
 Speculative positions are relatively
extreme still.  Sterling seems particularly vulnerable.  
We do not think the widening
of the cross-currency basis swap in the dollar’s favor is much more than a
particularly intense bout of year-end funding needs.
 It is
particularly pronounced in Europe.  Australian dollars, for example, can be swapped for dollars for three months at a premium to US dollars.  The
dollar premium over the yen is in the area it was at the end of last
The dollar premium for euro
swaps is at its most extreme since 2012, while the dollar premium for sterling
swaps appears to be at a record extreme.
  EONIA jumped at the end of November, and it has spent the first half of December
gradually returning to its longer-term
averages near -36 bp.  
When the debt ceiling is lifted, the adjustment of the US Treasury
cash holdings will drain around $400 bln of liquidity via mostly bill sales,
and this may raise dollar premium on cross currency swaps next year.
  Regulatory incentives may also
influence the availability of dollar funding.   
The Bank of Japan meets in
the week ahead.
is most unlikely to change policy.  It may also be a little early to
seriously discuss a more flexible approach to the 10-year yield target. 
Also, there is nothing quite like have critics on the governing board that may
want take new action to reach the 2% inflation target to make Kuroda appear

Less appreciated is Abe’s
tax initiative.
the end of last week, the government announced a targeted corporate tax cut and
progressive changes individual taxes.  The corporate tax cut was for
companies that “sharply increased wages.”   If businesses
follow the government’s tax incentives, the statutory rate could fall to 20%
from 29.7% presently.  

The basic income allowance
will be increased.
  This tax break will be funded by raising the income tax on incomes
above JPY8.5 mln (~$75.5k).  Taxes are also likely to increase for
pensioners with incomes greater than JPY10 mln.  


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