- While tax cuts helped the dollar in September and October, political risks a headwind today
- With inflation accelerating and commodities racing higher, USD strength should be in store
- Yet outlook for the dollar remains unclear due to significance of tax cuts
In September, the US dollar rose sharply after inflation stopped decelerating and US politics started working in the currency’s favor. Looking at reliable front-runners of headline inflation, indicators such as 5y5y breakeven rates and commodity prices bottomed in June and began strengthening. The dollar’s move up in September thus makes sense given this context. Following the public revelation of Trump’s plans for lower taxes, the dollar continued to strengthen in October as the market digested the rising probability of lower corporate and personal income taxes. Given good GDP growth today, the dollar should strengthen further if inflation continues to accelerate. This is because the Federal Reserve tends to raise interest rates when growth and inflation are accelerating in tandem.
Once a tailwind, now more of a headwind
While talk of tax cuts helped the dollar in September and October, today the upcoming Senate vote is a short-term risk to the currency. Earlier this month, the dollar fell sharply after House Ways and Means Committee Chairman Kevin Brady spoke out against the Senate's plans to completely eliminate the SALT deduction. The dollar’s sensitivity to political developments highlights the extent to which news from Washington is driving the currency.
The upcoming vote is leading to uncertainty for two reasons. Firstly, Republicans have a much slimmer majority in the Senate, and can only afford to lose two GOP votes assuming Democrats vote along party lines. The Wall Street Journal recently reported that Republican Senators including Susan Collins and Ron Johnson are opposed to the bill in its current form. Given tough math, getting the tax bill through the Senate will be much more challenging than the House vote last week. The second issue is that the bill itself falls short for three big reasons. At a high level, the proposed changes will result in a lot of losers (e.g. upper middle-class earners in high-tax states) while introducing significant uncertainty to the US tax regime. While the tax code is admittedly messy, most Americans have planned their lives around the current rules. The dramatic changes envisioned by the GOP is thus destabilizing, and not in a good way.
As the US Senate is in recess for Thanksgiving, the first debate on the bill will not take place until November 28. Until the vote, expect headlines from Washington to result in US dollar volatility. Similar to the dollar’s previous sell-off based on Brady’s comments, politics will be a big driver of USD trading in the short-term.
Economic fundamentals tell a different story
Despite the negative headwind from politics, economic figures suggest a bullish outlook for inflation. As we described in more detail in a previous commentary, the outlook for inflation is brightening primarily due to rising commodity prices. Historically, changes in commodity prices have accurately foreshadowed inflation due to the importance of key commodities such as crude oil in the broader economy. Historical monthly CPI and Core CPI is shown below for reference:
Turning a corner? Inflation no longer decelerating
Looking at the dollar this year, the currency peaked in early March when the ‘Trump trade’ (i.e. rising inflation) was in vogue. After Congress failed to pass healthcare reforms, both actual inflation and inflation expectations began decelerating. In turn, this led to dollar weakness. Today, the dollar stands at a crossroads.
Despite encouraging signs for the future based on historically reliable front-runners, the dollar may weaken from here due to the significance of the upcoming Senate vote. Earlier today, we downgraded our medium-term outlook on the dollar to bearish after the currency sold off last week.