One of our key market views at the turn of the year was that the U.S. dollar, though already significantly overvalued, would continue to appreciate in light of a shifting U.S. policy landscape. A united Republican Congress and presidency had increased the odds of fiscal stimulus which, coupled with monetary tightening already underway, created the potential for meaningful fiscal and monetary policy divergence between the United States and other major developed countries. As we explained at the time, such a policy mix was likely to boost the greenback against other major currencies.

Five months later, the dollar has instead fallen 3.8% on a trade-weighted basis (Exhibit 1).1 Below we take stock of what went wrong and what we expect going forward.

Asset Allocation and the U.S. Dollar

Fiscal Expansion: Reality Never Met Expectations

Without a doubt, the largest disappointment has come from fiscal policy. The combination of a border-adjusted corporate income tax, lower tax rates, infrastructure spending and offshore earnings repatriation was expected to attract international capital flows toward U.S. assets, and boost the value of the dollar. However, two major setbacks dramatically reduced the likelihood of meaningful tax reform in 2017:

  1. Healthcare reform needed to come first. Dismantling the Affordable Care Act (ACA) was supposed to provide an easy win and ensure a more favorable baseline federal budget to assess the merits of subsequent tax reforms. The House’s failure to achieve consensus on ACA replacement sharply slowed the legislative agenda. Further, the American Health Care Act (AHCA) that passed the House in early May will need to be rewritten in the Senate before Congress can move onto action on tax reform. The timeframe remains highly uncertain.
  2. The border-adjusted tax (BAT), an integral source of financing lower business tax rates, met strong resistance from important industry lobbies, the administration, Congressional Democrats and key Senate Republicans. The BAT was Speaker Paul Ryan’s “secret sauce” designed to find a large source of offsetting corporate tax revenue that would allow significant tax cuts without widening the budget deficit. Without it, tax cuts that could be passed via the budget reconciliation process (without Democratic support) would have to be much smaller or temporary in nature if they were to widen the deficit.

At this stage, we believe any meaningful progress on tax reform seems postponed to next year and, if it does come to bear, will likely be more modest in scope. While the repatriation of foreign corporate profits is still likely to be included, a border-adjusted corporate tax no longer looks feasible. In addition, while infrastructure investment continues to feature prominently in President Trump’s speeches, the investigation into the Trump campaign and Russian interference in the election threatens to further derail the legislative process.

Monetary Policy: Hiking Cycle Still on Track, at Least for Now

On the other side, the Federal Reserve has proceeded on its tightening cycle in line with expectations, supporting the U.S. dollar via higher interest rate differentials (i.e. carry). In fact, the dollar is one of the highest-yielding currencies across developed markets (Exhibit 2).

Asset Allocation and the U.S. Dollar

Today, the critical question is whether the U.S. private sector will be able to sustain its positive growth momentum without the previously anticipated fiscal stimulus. To be sure, growth and inflation data have slowed in recent weeks, posing downside risks to the Fed’s rate projections (Exhibit 3).

Asset Allocation and the U.S. Dollar

Portfolio Implications

In light of these developments, we have reduced our portfolios’ overweight positions in the U.S. dollar over the past few weeks—primarily by trimming currency hedges in the euro. However, we continue to express relative-value views in high-yielding emerging market currencies such as the Turkish lira, Russian ruble and Indian rupee versus their developed-market peers, including the Japanese yen, Swiss franc and Canadian dollar. The framework of policy divergence we laid out earlier this year may still come to pass next year if tax reform becomes a reality. For now, though, we are less optimistic on the dollar over the next six months.

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1 As of 5/19/17.