Talking Points:
- Failure to pass healthcare reform has markets questioning the viability of US President Trump's ambitious fiscal stimulus plans.
- Lack of clarity over US fiscal outlook means faster Fed rate hike cycle is unlikely; two more rate hikes for 2017 in question now.
- The crowd has increased their net-short EUR/USD and net-long USD/JPY positions, which means a US Dolllar low may not have been found yet.
For the US Dollar, March couldn't have gone any worse. After the Federal Reserve made clear at their March 15 policy meeting that they had not factored US President Donald Trump's ambitious fiscal stimulus objectives into their Summary of Economic Projections (SEP), markets were given their clearest signal yet that the "Trump reflation trade" got far too ahead of itself.
As I wrote before I went on holiday last week, "the uncoordinated rollout of the Affordable Care Act replacement (ACA or Obamacare), the American Health Care Act (AHCA), is a poor litmus test for future policy endeavors. The logical assumption is, given the disdain by Republicans over the last 8 years towards the ACA, this should have been a straightforward legislative process now that the GOP controls the House, the Senate, and the White House, and thus, why would markets be correct in thinking that more ideologically challenging legislation like a $1 trillion infrastructure spending bill pass with much ease (if at all)?"
It seems that this fear for the US Dollar is being realized. If a bout of deficit spending is now unlikely to materialize, the Federal Reserve will have no reason to push up expectations for a faster-than-previously-anticipated rate hike cycle. As per the Mundell-Fleming framework (or IS-LM-BOP model), given the United States' high capital mobility, loose fiscal policy should lead to a rise in inflationary pressures, which in turn should necessitate tighter monetary policy from the Federal Reserve.
In reverse, the diminished prospect for fiscal stimulus means inflationary pressures won't rise to the degree previously thought, so the Fed won't be inclined to hike more than what's priced into markets already. In fact, a look at Fed funds futures this morning shows that two more rates in 2017 - the market's base case scenario - are being priced out. So, while market participants may not see a direct connection between the failed healthcare vote and the US Dollar's dive in recent days, it's certainly there. US Dollar bulls should be more than concerned at this point in time.
Read more: Weekly Trading Forecast: Trump Trade Reversal in the Works?
--- Written by Christopher Vecchio, Senior Currency Strategist
To contact Christopher Vecchio, e-mail cvecchio@dailyfx.com
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