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

Carlo Allegri/Reuters

• 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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