We expect the dollar to continue to strengthen over 2017 –
corporate tax reform; potential hawkish Fed appointments; fiscal
stimulus; the dollar’s status as a high-yielder all favour continued
gains throughout the year.
Dollar cycle still has juice. The USD is hardly
stretched. Compared to a more than 10%y/y appreciation last January the
broad-trade weighted dollar is only 2% higher. More generally, looking
at previous cycles the dollar is perfectly tracking moves in terms of
pace and duration. All previous dollar cycles have lasted at least six
years with 30% moves. Given that the broad dollar troughed in 2011 there
is at least one more year to go (chart 4).
The Draghi trade is over. The ECB surprised in
December by tapering but it is not clear this is bullish for the euro.
First, the prospect of a sell-off in European fixed income hardly makes
European bonds an attractive investment. Second, the correlation between
peripheral spreads and EUR/USD has flipped back to negative. During
“whatever it takes” more QE and narrowing yields were associated with a
weaker euro. The relationship has now flipped because less QE may be
associated with higher redenomination risk and a lower euro.More
generally, there is an inverse relationship between higher volatility in
the German bund and foreign portfolio inflows: when markets become
volatile foreigners shy away from Europeans assets. With French, German,
Dutch and likely Italian elections all due this year, the market
reaction to a negative political surprise will be very asymmetric for
Valuations and European basic balance Our model of
the European basic balance suggests EUR/USD “fair value” is already
below 1.00 given record portfolio outflows that are far larger than the
current account surplus. EUR/USD valuations are not yet extreme, with
typical over/under-shoots being around 30% or 85cents for EUR/USD.
Sell EUR/USD targeting at least 95cents. We are bearish for the year and we see risks to our 95cent forecast as skewed to the downside.