Richard Franulovich, Head of FX Strategy explained markets are eyeing off a near-term USD peak as the ECB sheds some of its caution in recent communications, key EM markets stabilise for the time being and as US midterm elections come into focus.
Key Quotes:
“Yield spreads continue to march in the USD’s favour.”
“Fed Governor Brainard noted recently that fiscal stimulus was boosting the short run r* neutral rate above its longer term, implying that Fed Funds will also have to run on the tight side of neutral for a while. The same logic applies to the USD; all other things equal the USD’s short term equilibrium level has been rising lately too.”
“The well-worn outperformance thesis favouring the USD,” is siding.
“The US PMI stands head and shoulders above the Eurozone.”
“US GDP is accelerating vs her major trading partners and the momentum in yield spreads is rising strongly in favour of the USD.”
“Slide two highlights the same message from a short term perspective, noting the relative strength of our US data surprise index vs the G10.”
“However, long USD exposure appears to be elevated and higher than could be justified even allowing for the US’s superior growth credentials (see slide two). That may be why the USD has struggled lately even as its equilibrium level has been rising.”
“The scale of US outperformance appears to be relatively extreme too; after all market pricing for the Fed is beginning to match the dots with two hikes mostly discounted for the remainder of 2018 (same as the median dot) and about +40bp for all of 2019, up from just +25bp at the start of the month. That is still shy of the 3 hikes from the median dot for 2019 but at least the gap is shrinking.”
“Beyond that market pricing for Fed tightening does not incorporate any risk that Fed Funds could rise for a period above longer-run neutral as alluded to by Governor Brainard. That risk should trigger another yield fueled leg up in the USD but markets won’t treat that as a serious risk near term and the Fed won’t yet feel compelled to signal that risk for sometime either; much depends on how the US economy performs and how financial conditions evolve when rates first hit neutral.”
Share
