Francisco Vidal | The emphasis put on the Federal Reserve’s actions and the US’ economy’s favourable performance over the last few years led to the debate over the possibility of the euro and the dollar reaching parity gained momentum at end-2016 and at the start of 2017.
In the short-term, the experience reminds us that nothing should be ruled out in the matter of currencies. That said, if we put things into perspective and give some form to scenarios which go beyond simply focusing on the Federal Reserve’s moves or taking for granted the stimuli proposed in the US, it’s clear there are reasons to expect the recovery in the euro.
Beyond the Fed
The point we need to consider is that it’s not just what happens in the US economy which marks the future of the cross between the euro and the dollar; the scenario in Europe should also be very much at the forefront. The political risks in the EMU have not taken shape and the majority of the “grand coalition” formed by the CDU and the SPD is not at risk ahead of the German elections this autumn. That said, in terms of currency the favourable performance of our region’s economy so far this year is seen as more important.
Eurozone GDP expections are improving and in 2017 it will be close to last year’s figure, while the US seriously has to consider the possibility that economic growth will once again disappoint the market for the second consecutive year. Even though the slow down in US economic growth in the first quarter becomes temporary, something the Fed defends, currently it’s reasonable to expect that growth will be slightly below 2% this year. And we can’t rule out that it converges with that of the Eurozone.
The situation exposed in the European area nurtures financial stability; a key question for the ECB, which is living with the recovery of inflation in the Eurozone, despite being closely linked to the base effect of energy prices. The conjunction of these factors provides a refuge for our central bank’s progressive change in language. The first milestone could be established in June as a prelude to more decisive signals in September, just in the run-up to the German elections.
In no way would the current 60 billion euros of asset purchases up to December be at risk and the central scenario continues to point to a progressive removal of these purchases by our central bank. We could have an announcement in the autumn that this process will begin in 2018.
As far as the markets are concerned, the mere possibility of a change in tack in Frankfurt is sufficient for them to price this in, moving towards a situation where the co-existence of the ECB’s less generous “mode” with the implementation of the Federal Reserve’s exit strategy will be valued. Then not everything revolves around the Fed and the scenario in the EMU will have a lot of influence on the euro. But also specific obstacles to the stimuli discounted in the US and the gradual appearance of a critical stance on questions like the real impact of deregulation on US economic growth.
Cutting taxes is the star stimulus proposed by the new US administration and initially it seems very aggressive. The US president is considering lowering corporation tax from 35% to 15%, reducing the number of tax brackets from seven to three along with a cut in the maximum rate, the elimination of inheritance tax and the application of a “very competitive rate” for those companies which repatriate profits.
As you can see, we are talking about very ambitious measures at a time when the US public coffers are facing a situation which is more complicated than the one existing when other big tax cuts were implemented. For example, under the mandates of George W. Bush or Ronald Reagan. A situation explained by the forecasts of the US Congressional Budget Office (CBO). Its base scenario points to an increase in the public deficit to 5.0% of GDP in 2027 and 9.8% in 2047, with federal debt standing at 88.9% and 150%, respectively.
Taxes and public revenues
Public revenues start from a reduced level in the US, as exemplified by the fact they represented on average 17.4% of GDP between 1967 and 2016. Proposals proposals like the one realised will reduce this figure. The contribution from inheritance tax to the public coffers is residual but not that from personal income tax and, even, from corporation tax. Adjusting these tax rates could cut tax revenues by 2 billion dollars over a period of 10 years. That said, its estimated at around 1.5% of GDP for this year.
Given this backdrop, it’s reasonable to expect there will be opposition from certain groups of Republicans to the fiscal stimuli’s current structure. This is above all because the big problem in the US is that public spending is drifting upwards. The CBO itself estimates that this will rise from 20.7% of GDP to 23.4% in 2027 and 29.4% in 2047, taking as a reference point the legislative framework in place at the start of 2017. The new US administration will defend the fact that the implementation of tariffs and the proposed health reform, which will cut the deficit by 337 billion dollars in the next decade, will tackle this problem. But this would be no more than a “sticking plaster” when the spending problem has its origins in the ageing population. In the US, the number of people over 65 is double that of 50 years ago. It’s predicted this will increase by over 3o% until 2027, representing 22% of the population in 2047.
So caution about the final essence of the tax stimuli in the US is obligatory and, above all, with regards to the time periods for their planning and coordination, as we are reminded of by the obstacles to the afore-mentioned health reform.
An ideal fiscal scenario
The most optimistic expectations for US economic activity would only be possible against the backdrop of an ideal fiscal scenario. This would also imply that all the revenues freed up would be earmarked in their entirety for investment and spending and this looks pretty difficult. In other words, the main leverages for launching US growth, including deregulation, should be cautiously taken into account, obliging a similar attitude towards the dollar’s performance.
Neither does the expected repatriation of US companies’ profits change this stance. In the first place, the importance of the flows derived from the real economy is residual in the dollar market compared with that from the financial side. And in second place, most of US firms’ profits held overseas would already be dollar-denominated. Then, from the US’ own perspective, the head winds for the economy and the dollar are not as strong as was discounted at end-2016. At the same time, the euro’s fundamentals are currently better than expected and, in the future, can count on the support of the ECB. In summary, looking beyond just the short-term, the euro’s recovery against the dollar would be on the table.