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 unchanged.

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 majority.

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 Office).

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 Democrats.

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 adjustment.

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 deficit. 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 holdings.

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 cited 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 tensions.

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 found 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 advantages.

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 analysis.