The USD has been in retreat of late. It appears that goldilocks and the USD bears are playing for the same team these days.The recent underperformance of the USD reflects investors’ scepticism that the Fed will be able to hike anytime soon.
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The view seems predicated upon the subdued global inflation expectations and concerns that the apparent NFP strength is not translating into higher incomes especially as falling labour productivity makes sustained wage increases less likely. The lacklustre US capex recovery further dashes hopes that resilient household demand can boost business spending and investment over time.
Even if the US recovery lacks vigour and is relying heavily on household spending and services growth, it is one of the few bright spots in the gloom of ever slower global growth. Better still, the lack of inflation pressure means that the Fed is in no hurry to normalise rates and thus keeps global financial conditions very accommodative. Last but not least, weak USD helps prop up commodity prices and thus puts a floor under the global inflation expectations. All that has been supporting market risk sentiment, propelling stocks to new highs and fuelling investors' demand for carry in recent days.
In other words, the USD bears and Goldilocks are working in perfect harmony. The question is whether this is sustainable over longer-term? We think that the answer to this question is no.
With the USD trend-appreciation having stalled in recent months, the global financial conditions continuing to ease and the modest economic recovery still underway, the Fed should be able to normalise policy in December. This will be consistent with the conditions that made possible Fed liftoff last December - improving US data and fairly calm global (FX) markets that translated in easy US financial conditions. We further doubt that Goldilocks could stick around for too long if/ once the USD bears leave the scene.That is, a Fed rate hike may put an end to the latest rally in risk. This is because a big chunk of the recent gains in commodity and higheryielding currencies could be traced back to the expectations of persistent Fed dovishness. With that gone, valuations will have to adjust. To be sure, an alternative scenario is possible where Goldilocks joins the team of the USD bulls instead, so that the USD rallies and risk sentiment remains supported. That seems less likely in our view given the persistent investor worries about the global recovery and the negative impact from a renewed tightening in global monetary conditions.
A Fed rate hike still seems like a long-term prospect in the current markets and we would expect that the carry seeking behaviour will continue to support the antipodean currencies. The USD may regain some strength on the back of further improvement in the US data (retail sales on Friday), however. Coupled with lingering downside risks for oil prices, we believe that CAD continues to look vulnerable. EUR and JPY remained rather resilient against USD even as they lost ground against commodity and higher-yielding currencies. A potential recovery could see a reversal of recent EUR/USD gains and may support USD/JPY. That said, it maybe too soon for a trend-reversal higher in USD.