The market has not been impressed by the recent progress in US tax reform, despite improved chances for an agreement before year-end, according to analysts at Bank of America Merrill Lynch.
Key Quotes
“The USD remains weak and our latest flows show hedge funds and real money buying EUR/USD in recent weeks. The rates market has not moved to price more Fed hikes and the curve has actually flattened further. It seems to us that the consensus is that the tax reform will not matter much, which is consistent with what our survey data and the feedback during our recent client meetings suggest.”
“In contrast, we have been arguing that the US tax reform is a big deal and will support the USD in early 2018 for the following reasons:
- It includes substantial fiscal stimulus, at a time when the US economy does not need it. The current plan increases the deficit by 1.4tn in the next ten years. In practice, it may be more than that, given optimistic growth assumptions. Our economists forecast that the boost to domestic demand will increase real GDP growth by an annual 0.3 to 0.4 percentage points in 2018 and 2019. This is while the US economy has already reached full employment, has closed its output gap and is growing above potential. Our economists expect US inflation at 2.3 percent next year, with upside risks from tax reform.
- It could lead to more Fed hikes. Even without tax reform, we expect three hikes by the Fed next year, consistent with the dot plot. With tax reform, the Fed may hike four or even five times next year. The market is still pricing only three hikes in 2018-19.
- It should trigger substantial profit repatriation. After paying the lower tax on the stock of cash abroad, there is no reason for US companies not to bring, at least, some of this money back home. Moreover, zero US tax rate from future profits from abroad will lead to permanently more repatriation, in our view. Some of this money will have to be converted into USD and some of this money will go into capex.”
“The risks are asymmetric, in our view. One can discuss the details and number estimates of the above, but the market seems to be pricing almost nothing. Otherwise, we cannot explain why rates and FX have not moved following the Senate vote last week. The market overreacted on the impact of tax reform a year ago but is underreacting now. The truth is somewhere in the middle, in our view. We expect the USD to strengthen early next year, as the market will buy the tax reform fact, after having sold the rumor.”
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