Bank of America has come up with the 'ultimate tax reform trade' that everyone is missing


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  • Bank of America Merrill Lynch’s David Woo says
    he’s more optimistic than the consensus view on the GOP’s
    ability to pass tax cuts, and on their market
    impact. 
  • The “ultimate tax reform trade” is a bet on a steeper
    yield curve, specifically the 2s-10s curve, according
    to 

    Woo. 
  • Tax reform should increase the deficit and strengthen
    the dollar, both of which would steepen the spread between 2-
    and 10-year Treasurys, he forecasts. 

If you’re betting that tax reform would be a bigger deal to
financial markets than others think, Bank of America Merrill
Lynch has a trade for you. 

A so-called bear steepener, which bets that long-term
interest-rates will rise faster than short-term rates, is “the
ultimate tax reform trade,” according to David Woo, a BAML FX,
rates, and emerging markets strategist. Specifically, Woo
recommends bear steepeners on the spread between 2- and 10-year
Treasury yields as one of his top 10 trades in the new
year. 

“One of the main consensus views going into next year is
that tax reform means little and US growth remains in a 2% range,
with yield curves and term premium heading into a typical
late-cycle story: lower term premiums, flatter curves, lower
inflation risk premium and lower vol,” Woo said in a
note. 

“We disagree. 
We are more optimistic than
consensus on both the ability of Congress to pass tax reform in
the coming month(s) and the impact that it is likely to have on
markets. “

In our view, rarely has the longer-term
rate outlook been more dependent on the short term.”

The Senate passed its version of the Tax Cuts and Jobs Act
overnight on Friday. It’s now set to
hash out the differences
between its bill and the House
version that passed mid-November.

Lower corporate tax rates for corporations and some households
would impact interest rates in three ways, Woo said. First, tax
cuts and deregulation on businesses could increase the neutral
rate at which, in theory, the economy is growing at an optimal
pace. Second, as the deficit increases to as much as $1
trillion in 2020 in BAML’s view, interest rates could head in the
other direction. Some
studies
have shown that deficits and interest rates have an
inverse relationship. 

Finally, Woo expects the dollar to strengthen as companies take
advantage of a lower repatriation tax to bring back cash they’ve
left overseas. A stronger dollar can reduce foreign demand for US
Treasurys, in turn lifting yields; Woo noted that the weaker
dollar this year encouraged more official buying of
Treasurys. 

Based on our estimates, tax reform
alone 
— were it to deliver a
1% deterioration in forward deficits, a 1% decline in foreign
buying/GDP and a 0.25% increase to long term
growth —
 could be worth 60-100bp on
long-term real rates over the coming years,” Woo
said. 

A few things could go wrong with this trade, including yet
another incorrect interest-rate forecast. Rate strategists have
collectively ended up wrong on the level of interest rates for
several years. Investors at home and abroad continued to find US
Treasurys more attractive than expected, sending their yields
lower.

And, if Congress fails to pass tax reform, markets would quickly
change their outlook on how many times the Federal Reserve would
raise interest rates, Woo said. 

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