Yellen-Induced Carry Trade At A Tipping Point: What's The FX Trade? - TD

We think the Yellen-induced carry trade is close to reaching a tipping point. For sure, it seems unlikely a fresh USD rally will exceed the highs seen over the past two years. Even so, we think in broad terms we can still see the greenback eke out narrow gains against most of the G10 over the next quarter in line with our forecasts.

We expect the improvement in US fundamentals (housing, employment, and consumer growth) and steady rise in core inflation will lead to further tightening in Fed policy this year. We have higher conviction levels that the commodity-sensitive currencies are more at risk than the European currencies given valuation and positioning issues but we still see them lower too from here.

Our short-term indicators suggest AUD, NZD and CAD are the most at risk for a correction. Our high-frequency drivers show that the range of mis-valuation of these currencies is between 2.5 to 4.0%. These tools flag AUD as the richest, implying a move back 0.737 over the next month. NZD and CAD also both look rich against our tracking models, but CAD is 2.5% from suggested levels while NZD is about 3.5% expensive (Figure 5).

All told, we like fading the AUD and NZD rallies and still prefer long CAD exposure in the dollar bloc but still see this group lower against the USD in the coming months.

Finally, we think EUR should stick to its recent trading range of (1.08 to 1.15) but like fading it as we approach the upper end of the range with short EUR/CHF one of favorite Brexit trades.