USD: Fundamentals Firmly Favor Dollar Up; We Stay Firmly Bulls
A natural tendency is to examine previous episodes of Dollar over- or undershoots, with the goal of trying to estimate some kind of ‘half-life’. We are not big fans of that.
Take the undershoot from a year ago, which began with mounting China fears. The Dollar fell sharply versus the majors, while rate differentials – even with successive dovish shifts from the Fed – were relatively stable. That episode ended with the election, which lifted the 2-year rate differential firmly in favour of USD. This time around, Exhibit 18 shows that the decoupling of the Dollar coincides with the stream of communications from the new administration from early January, which have signalled discomfort with a strong Dollar.
The underlying driver of this decoupling is therefore very different from the previous 2016 episode and we doubt it holds much relevance.
We would say two things:First, we think the ‘Dollar down’ rhetoric says more about the constraints facing President Trump, rather than likely outcomes. After all, a policy mix that combines fiscal stimulus and protectionism is hard to reconcile with a weaker currency, even if that is what the new administration wants.
Second, speculative Dollar longs are more modest than they were a year ago, in particular where EUR/$ is concerned (Exhibit 19). The fundamentals firmly favour Dollar up. The market just has to get used to the new administration and good data should help with that. The market is pricing 64bp in tightening through 2017, well below our US Economics team’s forecast of 100bp.