Currency Traders Spot Fatal Flaw in Republicans

dollar Forecast — Currency Gold Silver Reports ✅ — In Washington D.C., one of the selling points of an ambitious border-tax plan rests on a key economic assumption: The dollar will appreciate enough to offset any increase in the cost of cheap, imported goods that so many Americans have come to rely on.

It’s just Econ 101, backed by well-established macroeconomic theory.

But on Wall Street, traders and strategists who make a living in the $5.1-trillion-a-day currency market say such notions are preposterous. Even if congressional Republicans can set aside their differences to pass the proposed border-adjusted tax — a prospect that seems more remote with each passing day — you’d be hard-pressed to find anyone in the market who believes it will result in the greenback strengthening 25 percent, as the plan suggests.

Part of the reason has to do with what they see as a misinterpretation of the underlying theory when applied to the real world. But just as important is the fundamental failure of politicians to appreciate how unpredictable the vast, foreign-exchange market can be, especially when global economic drivers collide and trillions of dollars change hands every day.

“The FX market is the most difficult thing to forecast, and to build an inter-generational tax reform based on the assumption of what the FX market will do is a laughable notion,” David Woo, the head of global rates and FX strategy at Bank of America.

How the dollar responds is certain to have consequences that extend far beyond the currency market. If it fails to appreciate as Republicans expect, consumers and retailers that rely on imported goods (think Wal-Mart and Best Buy) will be hard hit and slow economic growth.

Currency appreciation is also a key political defense in arguing the plan — which taxes imports and exempts exports — isn’t protectionist and doesn’t violate World Trade Organization rules, as a stronger dollar levels the playing field between foreign and domestic products.

Simple Math

In fact, the dollar has given up most of its gains since the November election, which gave Donald Trump and the Republicans control of both the White House and Congress, partly as hopes for a quick passage of a comprehensive tax reform bill waned.

For Woo, it all boils down to simple math. Daily trading of goods and services between the U.S. and the rest of the world averages about $14 billion. That amounts to 0.3 percent of the $4.4 trillion in dollars transacted in the global currency market each day. In short, little more than rounding error.

Much of the ebb and flow in currencies are dictated by the vagaries of traders as they respond to changes in monetary policy, economic growth and political risk. At times, it can cause the dollar to veer away from levels that economists would consider rational using measures like purchasing power parity. To think that the dollar simply turns on trade policy would be naïve at best, Woo says.

Strong Assumptions 

Federal Reserve Chair Janet Yellen has voiced similar concerns.

“There is more than trade that affects a country’s exchange rate,” Yellen said in congressional testimony in February. “A strong set of assumptions is needed to believe that markets would fully offset those changes” caused by the border-adjusted tax.

To be fair, it’s not as if House Republican leaders are just making it up.

The plan’s assumptions about the dollar — that it will rise just enough to bring down after-tax import prices relative to locally produced goods — are rooted in a macroeconomic principle popularized by John Maynard Keynes in the late 1930s known as the “national income identity.” In its simplest form, it describes how a country such as the U.S. that saves less than it invests must automatically run a trade deficit.

With a proposed border tax of 20 percent, the U.S. currency would then have to appreciate 25 percent to restore the trade balance by increasing the purchasing power of the dollars used to buy imports, and reducing the competitiveness of American exports.

Real World 

House Speaker Paul Ryan, a key proponent of the Republican border tax proposal, said in February that the dollar’s rise is “obvious and mathematical.” Spokeswoman AshLee Strong pointed to those remarks when asked to comment for this story.

It’s all straightforward in theory, but in the real world, it’s anything but. According to JPMorgan Chase, adoption of a border tax could trigger tensions with trading partners or outright retaliation.

What’s more, the appreciation that Republicans promise may be delivered in the form of inflation instead of a stronger dollar. That happens when retailers pass on the tax to consumers or when sellers of locally produced goods raise prices to take advantage of increased demand. So it’s really the inflation-adjusted dollar (often known as the real exchange rate) that adjusts rather than the nominal rate, which JPMorgan estimates may rise as little as 6 percent versus major trading partners.

“The theory is only sound as it describes the real exchange rate, not the nominal exchange rate,” said Daniel Hui, a global FX strategist at JPMorgan.

Of course, there’s no way to know for certain how currencies will respond to a border tax because no system in the world is quite like it. And economists from Alan Auerbach of the University of California at Berkeley, to those at the Peterson Institute for International Economics point to a provision in the tax proposal that allows U.S. manufacturers to deduct the wages they pay from their taxable income, which could lessen consumer-price pressures and instead may lead to a stronger dollar.

“A wide range of respected economists believe that the dollar will appreciate substantially and quickly,” said Emily Schillinger, a spokeswoman for Kevin Brady, the Republican chairman of the tax-writing House Ways and Means Committee. “Additionally, our pro-growth tax reform plan will create jobs, grow our economy and ensure that Americans’ dollars go further.”

To UBS Wealth Management’s Thomas Flury, a number of risks could ultimately weaken the dollar. If local manufacturers fail to grab market share from importers, economic output could slow and force the Fed to ease up on the pace of its interest-rate hikes. Americans may just end up spending less.

The dollar depends on “how the Fed reacts,” said Flury, the global head of currency strategy at UBS’s Chief Investment Office. “At least in the beginning of the transition, you have to expect slower growth.”  — Neal Bhai Reports

source:- Bloomberg

Currency Traders Spot Fatal Flaw in Republicans | Gold Silver Reports

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Neal Bhai has been involved in the Bullion and Metals markets since 1998 – he has experience in many areas of the market from researching to trading and has worked in Delhi, India. Mobile No. - 9899900589 and 9582247600

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