Obama’s Tax Cut Extension: Bullish or Bearish for the Dollar?

In the “framework” Obama presented yesterday, he revealed his proposal to extend the existing tax rates across all income levels (including high-income taxpayers) for two more years. This includes the current 15% tax rate on most capital gains and dividends, and the marginal tax rates created in 2001.

More importantly, the plan details a two-percentage-point cut for the employee’s share of payroll taxes for 2011. This would cost the government around 120 billion USD, but it would also add 115 billion USD to the workers’ disposable income, and add as much as 108 billion USD to consumer spending figures. That’s an additional 0.7% for the fourth quarter GDP in 2011!

Other bargains in Obama’s list include a 13-month extension of the Federal unemployment benefits, an expansion of earned income tax credit, of college tuition tax credit and child tax credit.

Bull and Bear
When news of the proposed tax cut extension hit the airwaves, risk appetite surged and caused a rally in equities and higher-yielding currencies. Coupled with poor U.S. employment figures and a prospect of a rate hike from China, further stimulus from the U.S. government didn’t sound like good news.

Because of that, the dollar got clobbered by its major counterparts, save for the Japanese yen, as traders weighed the possible strain the additional stimulus could put on the U.S. dollar.

But all that seemed to be a knee-jerk reaction as traders started to buy up the dollar again after they had fully digested the news. The risk rally quickly fizzled out and reversed when traders realized that the tax cut would actually be helpful to the U.S. economy in the long run. EUR/USD, GBP/USD, and AUD/USD all fell like store prices during the Black Friday sale.

4-hour U.S. Dollar Index

As I’ve said in my non-farm payrolls review, it seems that the market is starting to give more weight to the underlying fundamentals of currencies. Take a look at how the dollar reacted when the NFP report was unable to meet expectations. Instead of rising on account of risk aversion, the dollar actually fell across the board and posted huge losses against its major counterparts.

David Rosenberg, a well-known economist from Gluskin Sheff, said that the program is equivalent to around 300 billion USD worth of stimulus. That being said, unless some terribly bad news comes out of the U.S., the dollar could end up being the “currency of choice” for the holidays!