USD: Repeating 2016? What Is The Trade?
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Repeating 2016?
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 correct.
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.
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