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U.S. tax cuts to eventually underpin dollar, but may sink in meantime

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12/07/2017 | 01:05pm CET
House Majority Whip Rep. Steve Scalise (R-LA) looks on during a news conference announcing the passage of the

The U.S. dollar is set to lose a bit more ground against other major currencies next year, challenging a view among most foreign exchange dealers that aggressive tax cuts just passed by the Senate will have a positive effect on the currency.

The latest monthly Reuters poll, taken Dec 4-6, found a slight majority of currency strategists who answered an extra question thought that if the final bill looks similar, it ought to support the dollar beyond a year from now too.

Still, the forecasts collected this week on how the dollar will perform were notably weaker, with the 12-month euro forecast the strongest in over three years of Reuters polls.

That suggests any boost to the already-strong U.S. economy the tax cuts may provide remains unclear.

"In terms of the impact of the approved fiscal reform, analysis suggests that, at best, there will be a slightly positive economic impact in the short-run which could help to contain the USD weakening trend seen in most of 2017 against its G10 peers," said Roberto Cobo Garcia, strategist at BBVA.

The dollar has lost close to 9 percent against a basket of six major currencies this year, on course for its worst calendar year performance in 14 years.

The bill that narrowly made it through the Senate last week is expected to scrap many exemptions and reduce the corporate tax rate from 35 percent to 20 percent. That is likely to increase the budget deficit by about $1 trillion over a decade.

Median forecasts from the poll put the euro <EUR=> at $1.22 in 12 months. BBVA, who rank in the top third of most accurate forecasters for 12-month euro views over the past year in a sample of nearly 60, holds the median view.

ING Financial Markets, among the top 10 most accurate euro/dollar forecasters on a 12-month horizon over the past year has the highest forecast at $1.30.

The European Central Bank is widely expected to wind down its asset purchase program by the end of next year, which is nudging the euro higher against the dollar.

Over the past year, the path of least resistance for the dollar has been lower. That is despite the U.S. Federal Reserve's campaign, launched two years ago, to gradually lift short-term interest rates.

About a third of the analysts who said the final tax bill will support the greenback beyond a year from now still had forecasts for a weaker dollar over the next 12 months.

Only a month ago, a poll of the same analysts said major tax cut legislation was required to push the dollar higher.

Earlier this year, several currency strategists who had aggressive dollar forecasts - some were even calling for the euro to fall to parity to it - had to quickly sweep away those views as instead the euro bolted higher.

Kit Juckes, market strategist at Societe Generale, notes that the most recent dollar peak in real terms, struck a year ago, was the lowest of three peaks since 1980. That, he argues, is because real Treasury yields have barely moved up.

"The 1985 dollar peak was associated with 10-year note yields almost 10 percent above inflation. The 2001 peak followed a rise in real yields to 5 percent. So far, the peak in this cycle is a paltry 0.6 percent," he wrote in a client note.

"The bond market would need to do a lot better to justify a higher dollar peak," he noted. SocGen is forecasting the dollar to slip another 10 percent from current levels.

Currency speculators have raised their net short dollar positions to the highest in over a month, according to the latest data from the Commodity Futures Trading Commission.

Until there is more clarity on the final tax bill and when any ensuing stimulus is first likely to take place, downward pressure on the dollar may linger.

"We remain skeptical about the impact on investment and efficiency, which are the economic effects that would increase potential output and have a positive impact on the USD," noted BBVA's Garcia.

"Thus, we anticipate a limited impact that could be slightly positive in the very short term and slightly negative in the long run but broadly neutral in terms of long-term projections."

(This version of the story corrects a typo in headline)

(Additional reporting and polling by Sarmista Sen and Anu Bararia; Editing by Ross Finley and Toby Chopra)

By Hari Kishan

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