Currencies: Currencies: U.S. dollar has limited upside

Interest rates still give the U.S. dollar (USD) an advantage over other developed-market currencies, but the 25% appreciation predicted as a result of the so-called border tax is not in the cards.

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Holding breath for huge U.S. border tax boost?

Currency markets are waiting with bated breath for news on the destinations-based tax with border adjustment (the “border tax”), a policy proposed by Republicans in the U.S.House of Representatives. Under this policy, exports by U.S. firms would not be taxable and import costs could not be deducted from corporate profits. Because the U.S. has a$500 billion trade deficit, a 20% border tax could raise $100 billion per year. The policy would allow the U.S. to cut corporate taxes and potentially prevent American companies from shifting production overseas.

Proponents of the border tax, including House Speaker Paul Ryan, also say that it should lead to a super strong USD and have no effect on the nation’s trade balance. The border tax effectively acts like an import tariff and export subsidy. Economic theory says that an import tax would decrease American demand for foreign goods (and decrease demand for foreign currencies to buy those goods), while the export subsidy increases demand for USD. Less demand for foreign currencies and more demand for dollars would cause the USD to appreciate enough to wipe out the competitive effect of the tax. If successfully implemented, a 20% border tax could lead to a 25% appreciation in the dollar for the neteffect on trade balance to remain unchanged.

U.S. trade balance

Source: Thomson Reuters Datastream, as of January 2017.

That’s the prediction of a simple economic model. We are somewhat skeptical that the border tax will have such a big effect on the USD for the following two reasons:

(1) It is uncertain whether it will pass through the U.S. Congress. The policy creates big winners and big losers, and companies hurt by this policy (e.g., Walmart, which depends on imports but sells domestically) are fiercely lobbying against the tax. In addition, President Trump has not endorsed it (nor ruled it out).

(2) Even if the policy passes, other countries could threaten to retaliate with their own protectionist measures, blunting the effect of a strengthening USD. Having said that, the greenback still enjoys the benefit of higher U.S. interest rates compared to other major countries. This could push the dollar a little further against other major currencies, but given uncertainty around the U.S. border tax boost, expensive dollar valuation, and crowded long dollar position, the upside may be very limited.

Other major currencies

  • Euro (EUR)
    Eurozone economic data is improving rapidly, but uncertainty around eurozone politics still weighs on the euro. By far the most important political event is the French presidential election in April/May. A victory for populist candidate Le Pen would be a shock, potentially eclipsing the Brexit vote and Trump victory in terms of its impact on markets. While Le Pen says she intends to extract France from the eurozone, we think a victory for her in the crucial second round of elections is unlikely. According to most public opinion polls released in 2017, her support seems to peak at 40 – 45% of the vote and not high enough to win in a two-person race. Although the euro may come under some pressure in the run-up to the French election, we do not foresee severe disruption or a eurozone breakup scenario.
  • Japanese yen (JPY)
    This upward pressure from higher interest rates on the USD has played out mostly against the yen. As the BoJ is keeping 10-year Japanese government bond yields anchored around 0%, the interest rate differential between the USD and JPY has been widening sharply, putting pressure on the Japanese currency. Further depreciation could be limited by the already cheap valuation of the yen.
  • UK pound sterling (GBP)
    Britain is on the brink of evoking Article 503 of the Lisbon treaty to leave the EU. While Brexit has been the driver behind sterling’s dive in 2016, the pound has stabilized this year in a range of 1.20 – 1.28 GBP/USD. We think it is attractively valued and much worse news is needed to push it out of the range.

3 Article 50 of the Treaty on European Union sets out the process by which member states may withdraw from the European Union

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