Fiscal stimulus, an independent Federal Reserve and weaker USD form what we call President Trump's 'impossible trinity'. The President wants to boost US growth while keeping the USD from appreciating. This cannot happen with the currently independent Fed, however. Indeed, we expect fiscal stimulus in the US to fuel growth and inflation, lead to further normalisation of the Fed policy and support the USD across the board. That said, in the short term, the price action in the USD-crosses could remain a tug of war between President Trump's attempts to wage a currency war and investors' expectations of fiscal stimulus and Fed hikes.
Next week's US data and Fed Chair Yellen's semi-annual testimony should tilt the balance of risk in favour of a stronger USD in our view. Evidence of resilient domestic demand and inflation as well as indications that the Fed is on course to hike rates further should restore fading market confidence in the FX divergence trade. In addition, the US-Japan trade summit that starts today (10 February) in Washington could allay fears that protectionist rhetoric will stand in the way of further USD gains. That said, US protectionism remains a longer term risk that is still to be priced in by the markets
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EUR should remain vulnerable versus USD, dragged lower by political fears ahead of the Eurozone elections in the next few months. In addition, concerns about the next Greek bailout tranche could intensify ahead of the February Eurogroup meeting. The constellation of risks will continue to fuel fears about the rise of populism in Europe and the future of the Eurozone. In addition, the upcoming changes in the ECB's QE programme could further erode EUR's rate advantage while resulting in wider peripheral spreads. All this could play out as a perfect storm for the single currency. We keep our short EUR positions against both USD in spot and JPY via options.*
Elsewhere, focus will be on the February Riksbank meeting. With Swedish inflation and the economy recovering, the bank seemingly has every reason to sound more constructive. Nevertheless, potential concerns about the latest SEK gains that could hold the latest FX rally in its tracks would be of key importance for the markets.
Last but not least, UK data releases next week could lend support to views of the more dovish MPC members, with any gains in inflation offset by more evidence of weaker labour market conditions. Political uncertainty could resurface if the recent initiative for a second Scottish referendum gains traction. All this could leave GBP vulnerable to renewed downside correction.