Investors are trying to learn from historical developments. Therefore it is understandable that market participants talk about the
risk of getting caught up by a USD downward correction, such as that
seen from February to May 2016 when the Fed's broad USD index weakened
by 6.5%. Indeed, the start of this year and last year have
shown some similarities. Markets have largely priced in the Fed hiking
rates twice this year and the USD has started the year on a firm note
with the narrow DXY index trading at its highest level since 2002.
A different environment:
However, here end the similarities. Importantly, last year’s
rate-supported USD rally was at odds with China experiencing significant
capital outflows, equity markets selling off hard, commodity prices
declining and global inflation expectations falling rapidly. Relative to
January 2016, China's monthly capital outflows have moderated,equity
markets have rallied, commodity prices have pushed higher and so have
inflation expectations. Moreover, the USD's rally since September has
had very different characteristics compared to the rally witnessed going
into January 2016. In January 2016, it was high-yielding currencies
that sold off against the USD. Since September, the USD has gained
against low-yieldingFX with JPY weakening most. Accordingly, we are not
going down the path cited by some investors, stayingnervously on the
sideline, concerned that the USD may have a ‘déjà vu’ event - namely to
Good reasons for staying USD bullish:
All in, we see no repeat of last year’s 6.5% USD correction. Nowadays,
China is in a much better position in terms of controlling capital
flows and hence it is in a better position to deal with USD strength.
USD strength has not impacted EM as much as last year,hence
destabilising EM funding risks have been smaller. The likelihood of
seeing the Fed easing its projected path of hiking rates is less
developed compared to last year as the US is seeing increasing signs of
having closed its output gap. And lastly, threat of protectionist
measures will force the market to keep a bullish USD bias.
Bottom line: USD corrections offer investment opportunities against low-yielding currencies such as EUR and JPY.
*MS maintains a limit order to sell EUR/USD at 1.0650 in its strategic portfolio.