Week Ahead: Selective USD Gains To Extend Into NFP Release

Week Ahead: Selective USD Gains To Extend Into NFP Release

28 May 2016, 15:00
Vasilii Apostolidi

The policy divergence trade is back with a vengeance and investors are scrambling to buy USD against other G10 currencies. We suspect that the USD resilience will extend into next week ahead of the important US NFP release.

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The focus, as per usual, will be on earnings data, with investors looking for indications of a continuing build-up of wage pressures that should translate into higher core inflation and further tightening of monetary policy before long.

Potential disappointment from activity data next week (eg, GDP and PMI data out of Australia, Canada, Sweden and Switzerland, as well as PMI data out of China, Japan and the Eurozone) would highlight that the Fed will be hiking against the backdrop of a still rather fragile global growth outlook. In turn, intensifying rate hike bets should ultimately undermine market risk sentiment. We therefore believe that the USD gains should be sustained against commodity G10 currencies like AUD and CAD rather than safe havens like EUR and JPY.

An unexpectedly severe deterioration in market risk sentiment in the near term remains a potential risk for the USD rally. This is because the combination of strong USD, growing US rates, and weak global and US stock markets could once again trigger an unwarranted tightening of US financial conditions. And we know that, time and time again, the FOMC has 'blinked' in the face of weaker equities and surging USD.

The lingering uncertainty about the Fed outlook notwithstanding, we remain bullish USD over the longer-term because, despite its recent appreciation, the currency remains well below measures of fair value like the spread between 2Y US rates and the average G10 2Y rate. According to that measure, USD should be trading much closer to the highs of the year before long.

Elsewhere, we expect the June ECB meeting to strengthen the market perception that the ECB is no longer an active participant in the global currency war as it prefers to stimulate growth and inflation through the Eurozone's lending channel. In this respect, it will be interesting to see if the updated staff projections have maintained a fairly constructive outlook for EUR NEER.We suspect that the ECB meeting may discourage further EUR selling and continue to expect more upside for EUR/CHF.

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