The dollar could continue to flounder and the economy could fall into recession unless Congress moves on tax-cutting legislation, says David Woo, Bank of America Merrill Lynch’s head of global rates and foreign exchange strategy.

“The single biggest driver of the dollar is the outlook for U.S. tax reform. If tax reform happens, it will be very bullish for the U.S. economy. It will allow the Fed to hike rates, and be extremely bullish for the dollar,” said Woo.

Woo does see a strong chance for a tax bill. He said the recent weakness in the dollar has come as the Senate failed to pass a health care package, which Republicans had hoped to approve ahead of tax reform. The outcome is still unclear for health care, but Wall Street has remains convinced that Congress will try to push forward on tax reform.

“If tax reform doesn’t happen, the economy will be slowing and we’ll be in a recession within two years. The Fed will not be hiking rates and the dollar will be toast,” Woo said.

Woo said Fed Chair Janet Yellen highlighted how important tax reform is when she told Congress earlier this month that fiscal uncertainty was one of the biggest risks facing the economy. Traders focused on her comments about inflation in that testimony, and the dollar has sold off since then.

The dollar has also taken a hit as traders bid up the euro on expectations the European Central Bank will announce this fall that it is reducing its quantitative easing program. The dollar this past week fell 1.8 percent against the euro zone currency, as the market responded to expectations of a hawkish ECB versus a possibly more dovish Fed. The euro is up nearly 11 percent against the dollar this year alone.

“My view is until tax reform is resolved, one way or the other, the Fed is going to be sitting on its hands,” said Woo. The strategist said that there is also uncertainty around the investigation by special counsel Robert Mueller into the Trump campaign’s ties to Russia. This week, reports that the scope of the investigation expanded to Trump’s businesses weighed on the dollar.

“Obviously, the whole Mueller thing certainly that makes people think that tax reform is less likely to happen,” said Woo.

“I’m still very, very optimistic on tax reform. I think there’s a 90 percent chance tax reform gets done this year,” he said. “The only way tax reform gets done is the hard way, and the hard way would involve the president threatening to shut down the government and basically defaulting to get his party to vote on tax reform in September.”

Woo said President Donald Trump will only take that path if he believes he can get his way. “He knows the Republican party can afford this showdown much less than he can because he knows they could lose its majority in the House,” he said.

The dollar could continue its downward trajectory, with euro/dollar heading to $1.20 from $1.1674 Friday. He said on the downside, the euro could go to $1.10.

Source: Investment Cnbc
Shrinking dollar will be 'toast' without tax reform—Bank of America strategist