USD After The Fed: Back At The Crossroads; What's Next?
USD: The Pain Trade - Morgan Stanley More short-term USD weakness.
"The dovish Fed – discouraging USD bulls – has led to a de-positioning move supporting the once shunned currencies. GBP, AUD and many emerging market currencies fall into this category.
In this respect, the falling USD has the characteristics of a pain trade that seems to have further to run," argues Morgan Stanley.
"Central banks determine the short-term cost of capital, and thus steer money market flows.
However, long-term FX trends are driven by relative investment return differentials. When it comes to capital flows, other factors such as growth and productivity differentials come into play and here the US still leads,.
"For the USD to experience a long-term trend change requires more than a dovish Fed, in our view. It requires growth and output gap differentials shrinking. Markets may now be caught by surprise should US data strengthen, supported by easier financial conditions and a buoyant household sector running solid balance sheets," MS adds.
What will Draghi and Kuroda say? "A higher JPY and higher EUR are the flipside of USD weakness and with inflation chronically weak in Japan and the Euro-area, the BOJ and ECB responses have come into discussion again.
The dovish Fed may trigger a chain reaction of other central banks eventually taking additional easing steps. Risk should traditionally do well in anticipation of a further expansion of global liquidity. But surprising for us has been Europe’s equity markets trading south and not north following the Fed," MS answers.
Beyond short term, the current USD fall will run out of steam.
"The catalysts for a turnaround back to a USD rally will be either strong US data confirming the need for tighter monetary policy in the US this year or other central banks globally fighting back against their own currency strength," MS projects.
Dollar bulls need not fret says Janus Capital Portfolio manager Ryan Myerberg say that USD strength will continue despite the dovish slant the Fed has undertaken He see's at least two more Fed hikes this year which should keep the bullish dollar trend intact. He says that this week's USD unwinding is just a knee jerk reaction to the Fed.
- The longer term theme of USD strength against currencies facing strong disinflationary pressure and easing remains in play
- Long USD positions are being unwound on a more dovish than expected Fed is a knee jerk reaction
- If the Fed became more dovish with a much worse risk environment than now, we wouldn't have seen the same unwinding
- Other central banks like the ECB and BOJ are unlikely to sit back and watch their currencies appreciate strongly
- Long term view for the euro remains bearish while JPY is likely to be weaker on the margins
He may very well be right about the dollar trend continuing but my feeling is that the trade now is completely different to the one that took us from the 2011 lows. That was a trend that tracked what happened in Japan, the US and across the globe, and even that trend had various parts as we went through political and extraordinary monetary policies events.
I had an idea that this particular trend would be over when the Fed hiked because that was what 99% of longs were waiting for. The hike was the pinnacle of everything that went on in the years preceding it.
Now the USD trade is based on whether the US performs well enough now to warrant more hikes, not whether it's a continuation of what's been happening over the last few years. That's normality, adjusting rates and policy to nurse the economy, not to fight fires. Trade what the dollar means going forward, not what it meant in the past.
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The surprised dovishness of the Fed is leaving its mark on the rates market and USD.
In our view, it seems as though USD may be returning to where it was in February, unable to decide whether to appreciate or to depreciate in the medium term. As our rate strategy team points out it may be difficult for rates markets to price in more than one hike at a time. This means that the case for USD appreciation may be losing some support.
It will take time and unambiguously strong data for the rates market to heal and for rates investors to be willing and convinced to price in a more aggressive fed fund rates path. Only then will USD be able to resume its march higher.
This means that USD is likely to trade on its back foot for some time, which will likely have some repercussions on countries that were hoping for a weaker local currency.
From a trading perspective, we think that USD will likely trade on its back foot for some time, so USD crosses are likely to trade with factors specific to the crosses, rather than on general USD strength or weakness.
https://www.efxnews.com/story/32321/usd-after-fed-back-crossroads-whats-next-nomura