Following the Senate tax vote late last Friday, the US dollar rallied on Monday morning as markets raised their expectations of tax cuts becoming reality. The most inflation-sensitive pairs, such as USD/CHF and USD/JPY, enjoyed the biggest rallies. While initial momentum was strong, the dollar gave up a big portion of its gains later in the day. Looking at USD/JPY, the pair strengthened above 113 yesterday but ended the day at 112.40. The pair continues to trade near similar levels today.

According to markets, inflation still on the horizon

Following Trump’s victory in late 2016, markets were certain of higher future inflation given his promise of big government spending. Given the size of the US federal government relative to the overall economy, changes in government spending can have an outsized impact on inflation. Following the failure to reform healthcare in the first quarter of this year, investors have become apprehensive of the ‘Trump trade’ (accelerating growth and inflation).

Despite the promise of Trump’s economic agenda, which includes deregulation, tax cuts and increased fiscal spending, getting bills through Congress has been his clear weakness. As the promise of fiscal easing and more government spending seems remote, inflation expectations have fallen as a result. Even with strong GDP growth and two rate hikes in 2017 (with one more likely in December), currency markets continue to doubt the possibility of higher inflation in 2018 and beyond. A visual overview of recent inflation expectations are shown below:

Bet on Washington? No way!

(Click on image to enlarge)

Source: Federal Reserve Bank of St. Louis

Sustained dollar rally will require a bigger push

Looking at our trending indicators, the medium-term outlook for the dollar remains neutral. While the dollar rally in September helped break the bearish trend that began last April, a bullish trend remains to be seen. After strengthening between September and October, the dollar has been weak in November thanks to concerns regarding the differences between the Senate and House versions of the tax bill. This week, the dollar has only modestly strengthened following the Senate vote. The muted price action in the dollar suggests that markets continue to doubt Washington’s ability to get things done. After losing money on the ‘Trump trade’, few are willing to bet again on rising inflation.   

For the US dollar to change trajectory, a larger change is therefore needed. Potential catalysts include higher crude oil prices, getting the tax cut signed into law, hopes for Trump’s government spending plan, or a slowdown in Eurozone GDP growth (which would strengthen the dollar in relative terms). Today, none of these catalysts are supporting the buck as markets doubt US politics, while crude oil looks over-extended in the short-term. Looking at the Eurozone, GDP growth remains strong, which is helping the outlook for monetary policy in 2018. While many have forecasted a US dollar bull market in 2018, we continue to wait for a clear catalyst to emerge.