Tax reform, rate hikes are so far not helping floundering greenback

The U.S. dollar has started off 2018 where it left off last year — on the decline — and if forecasts for the currency to soften further prove correct, that could make the Canadian dollar’s recent ascent to 80 cents U.S. seem rather insignificant by the end of the year.

On Tuesday, the U.S. Dollar Index (DXY) fell below 92 for the first time in more than three months, after dropping approximately 10 per cent in 2017 — it’s largest one-year pullback since 2003.

A year ago, most of the market was bullish on the U.S. dollar, even though many doubted the Fed’s ability to hike three times in 2017, as implied by the Federal Open Market Committee’s dot plot for rate expectations.

Despite following through with the hikes, and the major tax reforms passed in the U.S., the greenback has lost ground.

“Once past the third move in a tightening or easing phase, a central bank loses its ability to shock the market or even influence it in a major way,” said Greg Anderson, global head of FX strategy at BMO Capital Markets. “That is where the Fed is at now, so we don’t think whether the Fed hikes two, three or four times will matter much for the USD index.”

If the U.S. tax plan was implemented with border adjustment taxes, the U.S. dollar would have likely seen a big rally. However, the reforms that were passed don’t appear to alter America’s relative competitiveness very much at all, and are unlikely to lead to widespread repatriation of foreign profits.

“It contains no carrot that entices the onshoring of overseas funds; firms will pay the tax whether they repatriate or not,” Anderson said.

If taxes and rate hikes turn out to be non-factors for 2018, that could leave the currency vulnerable to global growth and America’s deteriorating balance sheet.

The greenback typically declines in years of above-potential global growth, as stronger economies drive up commodity prices, and in turn, commodity currencies. Strong global growth also makes investment in emerging economies more attractive, causing money to flee developed markets.

If the IMF is correct that global growth will climb to 3.7 per cent in 2018, that would be well above its 10-year average World GDP growth rate of 3.4 per cent, which is roughly where potential growth probably lies.

The U.S. dollar also faces another negative driver in that reversals in America’s twin deficits (current account and federal budget), typically precede turns in the U.S. dollar by one to two years.

“The U.S.’s twin deficit fundamental has been deteriorating for the past two years and is likely to deteriorate further in 2018 and beyond due in part to the tax cuts,” the strategist said.

Considering these factors, and the fact that U.S. dollar phases tend to last five to seven years, Anderson anticipates broad greenback weakness in 2018 — although at a slower pace than in 2017.

Continued strength from the global currency that performed best last year — the euro — could also hurt the dollar’s relative valuation.

Meanwhile, the Canadian dollar recently hit a two-month high, and is back near 80 cents U.S. Although the loonie has been buoyed by WTI oil prices above US$60 per barrel and expectations for higher rates in 2018.

October’s GDP report dampened expectations of a rate hike that climbed as high as 50 per cent for January, driven by both strong inflation and consumer spending data for the tail end of 2018. The Canadian dollar is still underperforming all of the G10 currencies amid broad-based U.S. dollar weakness, but which could leave more room for the loonie to appreciate.