- Everything is going right for the dollar, except politics and inflation
- This is a big week for politics and inflation, with Core PCE and the Senate's upcoming tax vote
- While our view remains bearish, rising inflation can catalyze the US dollar
After peaking at the outset of the year, the US dollar has been disappointing in 2017. Accelerating GDP growth, two interest rate hikes (with another due in December) and bearish speculator sentiment have been insufficient to spark a dollar rally. Instead, the currency has been weighed down by Congress’ inability to get bills passed and weak inflation. Both assumptions will be heavily tested this week. On Thursday, we’ll see Core PCE figures (the Fed’s preferred measure of inflation) while the Senate tax vote is likely to take place later this week.
Don’t celebrate tax cuts just yet
With a 52-48 majority in the Senate, the Republican tax bill is far from a ‘done deal’. Beyond the issue of a slim majority, the current tax plan suffers from poor optics because of its complexity. As we wrote earlier, most Americans will find it difficult to be persuaded of the tax bill’s merits. Instead of choosing to cut tax rates across the board, the GOP has proposed a series of changes to existing deductions and tax bands. The problem with this approach is that many Americans will see an increase in Federal income taxes, creating many losers in the process. As Republican Senators grapple with the proposal, some will find it difficult to support the bill in its current form. Based on a report in the Wall Street Journal, Ron Johnson has publicly opposed the bill while several Republican senators have yet to endorse the document.
Following recent state elections in Virginia (where Democrats won the ballot) and accusations against Roy Moore (a Republican Senator from Alabama), Republicans look vulnerable. If Democrats win Alabama, the GOP’s majority in the Senate will fall to 51-49. Thus there is a strong likelihood that Senate Republicans will push to conclude the tax vote quickly. While a sense of urgency would be a good thing under normal circumstances, there is a rising risk that the tax bill will fail to pass the Senate given the inherent weaknesses of the current document.
Will inflation expectations finally turn a corner?
Looking at inflation, neither strong US employment nor a commodity market rally has been sufficient to spark inflationary pressures this year. While commodity prices are usually a reliable front-runner for headline inflation, inflation expectations as measured by 5y5y breakeven rates remain subdued. In an earlier commentary, we wrote that most commodity indicators are pointing to accelerating inflation in the near future (despite the market’s current pessimism).
In order to break the current narrative, upcoming Core PCE figures will need to accelerate towards the Fed’s 2% inflation target. The current consensus estimate for September Core PCE is 1.4% (up from 1.3% in the previous month). An overview of historical Core PCE is shown below as an illustration:
Slow and slower: Core PCE has been decelerating in 2017
As can be seen from the chart above, Core PCE peaked in the first quarter of this year and has decelerated for the rest of 2017. With inflation on a weakening path, markets are unable to price in rate hikes in 2018 and beyond. Thus the US dollar is likely to stay weak. In our view, meeting or exceeding the 1.4% consensus estimate will significantly brighten the outlook for the US dollar. This is because markets will begin to price a potential bottom in weakening inflation.
For now, US dollar outlook still bearish
Given the significance of upcoming events this week, the US dollar may soon return a strengthening trend. This is particularly the case if Core PCE figures meaningfully strengthen above 1.3%. With regards to the Senate vote, significant differences between the House and Senate tax bills will limit USD upside in the event of a positive vote. Reconciling the two bills via a 'conference committee' is a lengthy process, while the House is unlikely to accept the Senate bill without significant changes. Instead, we see the tax vote as a one-sided risk, with the US dollar likely to slide if the bill fails to get through the Senate.
After downgrading our medium-term outlook on the US dollar on November 20, our view remains bearish for now.