US Tax Reform in Jeopardy and the State of the Strong Dollar Policy

The focus in the market is shifting away from the Federal Reserve, for
which the consensus recognizes that the FOMC minutes probably make a March hike
less likely. 
  The CME’s calculations put the odds at less than
18%, while the Bloomberg estimate puts the odds near 32%.  Our own calculation is closer to the CME’s. 
Over the past week, the odds of a March hike have slipped, May has increased, and June is essentially

The focus is shifting to fiscal policy.  President Trump speaks
to a joint session of Congress on February 28.  It could be the most
important speech of the first 100 days of the Administration. 

The most important part of the speech for investors and businesses will talk about tax reform.  Treasury
Secretary Mnuchin still seems optimistic about tax reform and hopes to have it
completed by the Congressional recess in August.  He did not provide a full-throated endorsement of the border
adjustment.    Without the
estimated $1 trillion revenues that it was supposed to generate, the ambitious
tax cuts must be scaled back in terms of
size or duration.   

There are a couple of constraints
that many observers may not appreciate, after all, the Republicans have a majority
in both houses of Congress and the executive branch.
  Why can’t they
simply get what they want?  There are two main answers.  First
“they” as in the Republican officials are not a homogeneous. 
Second, for important legislation, 60 votes are needed in the Senate, and the Republican have a narrow 52-48

Of course, parliamentary maneuvering can allow the tax reform be passed
with a simple majority if it would not
generate a larger deficit on a 10-year horizon.
  This is why
you may recall, why Bush’s tax cuts expired.  Mnuchin created some wiggle
room suggesting that the dynamic calculations by the White House may be more
optimistic (on growth) than Congress (e.g. nonpartisan Congressional Budget

The Republicans plan on two main sources of revenue.  Abolishing
taxes associated with the Affordable Care Act (Obamacare) and the border
adjustment.  However, the replace and repeal of the national healthcare is caught up on the replacement
component and may not generate the tax savings that had been anticipated.  

Moreover, at least two Republican Senators have come out against the
border adjustment (Perdue from Georgia
and Cotton from Arkansas).
  Mnuchin’s words were guarded, but it did not sound as if it would be endorsed by the
President next week. Without it, Republicans will either have to scale back its
ambitious efforts or to find a compromise with some

Recall the main elements of the Republican plan, in addition to repealing
and replacing national healthcare. 
1) cutting the corporate tax
schedule to 20% from 35%, 2) cut and simplify household income tax, 3) offer an 8.75% tax holiday on repatriated earnings,
4) allow immediate expensing of the capex,
5) drop the deductibility for debt servicing,
and 6)  the border

Many economists had argued that economic theory dictates that the dollar
would rise to offset the import tax component of the border adjustment.
We were among the first to push back against what we thought was a naive view (here).
  Still, the prospects for it may have helped underpin dollar
sentiment.  Disappointment with Trump’s tax proposals next week could
weigh on the dollar.    

Rather than a large-scale once in a generation tax reform, without the
border adjustment there will either be a more common tax cut plan and/or a larger defic
it.  A larger
deficit would conflict with another concern of some of Trump’s team, as well as
some Republicans in Congress.    At the same time, some of the largest foreign holders of US Treasuries,
including China and Japan, are paring back on their Treasury

One of the themes that we have been tracking as it evolves is the
softening of some of the more extreme foreign economic pronouncements of the
Trump Administration.
  China was not
as a currency manipulator on day one, and Mnuchin indicated today
that a decision would not be until the
scheduled review in April.  With the PBOC intervening to support the yuan
not weaken it, the objective measures developed by the Treasury Department will
not be met…unless the criteria changes
in the next two months.  

After a feint, Trump has recognized that there is only one China. 
Although Trump is still talking about building a wall on the border with
Mexico, it appears to be a more expensive and less practical (wall through the
Rio Grande?) than it may have appeared.  NAFTA will be negotiations will
be re-opened, but the idea that the US will dictate the results also does not
seem particularly practical.  In fact, today Mnuchin played down the

There had also been some concern that the Trump Administration was going
to jettison the more than 20-year strong dollar policy. 
Trump himself
has been critical of many countries, including Japan, Germany, and China.  The
targets are not so new.
  They can be
in recent Treasury Department reports.  What is new is the
tone and channel of communication.  Mnuchin makes it sound like it is
primarily a stylistic rather than a substantive difference.  

Mnuchin appears to have given the nod
to a strong dollar policy.
  However, the way he did does not quiet all
the doubts.   He said that the strong dollar reflected the confidence in
the US and the outperformance of the US economy.  This is consistent with our emphasis on divergence as a major
driver of the dollar.  He recognized that a strong dollar is not an
unalloyed good, and in both the short and long-term, there are drawbacks and

By linking the strong dollar to a level, Mnuchin demonstrates he does not
quite get it. 
The strong dollar policy was never about the level of
the dollar.  After all, there have
been large fluctuations in the dollar since Rubin initiated the strong dollar
policy in 1995, and through it, the
strong dollar policy has not been abandoned
The strong dollar policy was meant as a
signal to US trade partners and creditors that the US would no longer use the
dollar as a weapon to get concessions as was the case from 1985-1995.  
Until Mnuchin signals this element of the strong dollar policy, investors may
not be completely comfortable with the US commitment.  

Of course, sometimes the Treasury Secretary must be a cheerleader. 
Mnuchin is playing this role.  He claimed that the dollar’s rally since
November was a vote of confidence in Trump.  The opinion polls do not
support this self-serving explanation.  In fact, the latest Quinnipiac
University survey found that those thinking that Trump is a good leader has now fallen four percentage points below 46% of the popular vote he won.  
There has been a dramatic deterioration in the difference between those who
approve and those who disapprove Trump over the past month.  There was a 13
point gap in his favor, and now its is a
17 point gap against.  

Also, we note that broad measure of the dollar has been trending higher
since mid-2014.
  It fell only one month in H2 14.   In 2015,
there were only three months that the Fed’s real broad trade-weighted dollar
fell.  In 2016, the dollar fell in February-April and then rallied rest of
the year, except for August when it fell by less than 1%.   The 2.3%
rally last November was the largest monthly advance in the cycle, though not to
include a role for monetary policy and for developments in Europe (like
extending QE longer than expected) may make for good TV but not robust


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