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Thoughts for the Week Ahead
Listen to the Fed, not just Trump

• While the USD came under pressure after Treasury Secretary Mnuchin’s comments last week, we expect the USD to remain supported this week as near-term Fed hike pricing could rise further. This week, President Trump’s speech to the joint session of Congress on 28 February will be keenly watched, but it remains to be seen how much new detail on his key policy agenda, such as tax reforms, will be revealed.
• Instead, the USD should be supported by a potential rise in near-term Fed hike expectations. If the Trump administration continues its discreet approach to its protectionist agenda, the Fed could actually hike in the first half of the year. Against this backdrop, the market pricing of a near-term Fed hike appears too low and we expect the market to price in greater likelihood of near-term hikes. Yellen and Fischer at their speeches this Friday could jawbone market in that direction and further acceleration in the core PCE deflator should help reinforce those dynamics.
• The overvaluation of the USD remains a concern but can persist with cyclical outperformance. Relative US economic outperformance and solid data are likely to support the USD strength despite its overvaluation.
Trade for the week ahead: Long USD vs. EUR and JPY going into this week given that EUR and JPY are the two most sensitive currencies to both the level of and any changes in short-term yield differentials vs. USD.

Overview: Listen to the Fed, not just Trump

Trump speech poses two-way risks for the USD :

While the USD came under pressure after Treasury Secretary Mnuchin’s comments last week, we expect the USD to remain supported this week as near-term Fed hike pricing could rise further. Treasury Secretary Mnuchin at last week’s media interviews revealed his willingness to pass tax reforms before the August recess but recognized the risk of delay. He also downplayed the impact of Trump policies on 2017 growth. This week, President Trump’s speech to the joint session of Congress on 28 February will be keenly watched, but it remains unclear how much new detail on his key policy agenda, such as tax reforms, will be revealed. Last week, the President said that details of the tax reform will be only released after health care plans in mid-to-early March. Hence, we do not necessarily expect USD strength to emanate from Trump’s speech, which poses more of a two-way risk, in our view.

USD support likely to come from a rise in near-term Fed hike expectations :

Instead, the USD should be supported by a likely rise in near-term Fed hike expectations. Our September rate hike forecast is predicated on restrictive trade policies depressing H1 growth; however, the Trump administration has so far not been pursuing such policies as aggressively as had expected, with Treasury Secretary Mnuchin revealing its more discreet approach to trade deal negotiations and labeling of currency manipulators. If this continues, we see a risk that the Fed could actually hike in the first half of the year, most likely in May or June, in line with many FOMC participants who view another rate hike as appropriate “fairly soon” (see January FOMC minutes: a Fed in waiting, 22 February 2017). The Fed is retaining its three-hike stance, especially given rising concerns about financial stability risks, and an early hike would give it more space to follow through on this. Against this backdrop, the market pricing of near-term Fed hike appears too low (~20%) and we expect the market to price in greater likelihood of near-term hikes (Figure 1; see Global Rates Weekly, 23 February 2017). Yellen and Fischer at their speeches this Friday, just before the black-out period, could jawbone market in their direction and further acceleration in core PCE deflator should help reinforce those dynamics.

Overvaluation of the USD remains a concern but can persist with a cyclical outperformance. Mnuchin recognizes the negative short-term implications of a strong dollar on the economy. Indeed, the USD appears expensive by most metrics, ie. USD REER is nearly two standard deviations above our fair value estimate (BEER model) and its long-term average (Figure 2). While valuation poses medium-term headwinds, cyclical outperformance of the US economy (as measured in marginal return of capital differential versus other advanced economies) has, historically, often led to significant deviation of USD from its fair value both in terms of scope and duration. Relative US economic outperformance and solid data are likely to support the USD strength despite its overvaluation.

Long USD vs. EUR and JPY given their sensitivities to short rate differentials

Trade for the week ahead: Long USD vs EUR and JPY :

Based on the views expressed in the overview section, we recommend being long USD vs. EUR and JPY going into this week. EUR and JPY are the two most sensitive currencies to both the level of and changes in short-term yield differentials vs. USD (Figure 3). February inflation data from both these regions are expected to keep up their recent pace. Draghi is focusing on the core inflation trend and likely to look through the energy-boosted headline number, while the focus for BoJ this year is whether to raise the 10y target rather than front rates, but this is also likely a fair way off (ie, we expect a hike in Q3). All in all, front-end rates are likely to stay low in both the EU and Japan.
This trade recommendation is valid from the Wellington open Monday morning to the New York close Friday.

 

Marketing communication : This document has not been developed in accordance with legal requirements designed to promote the independence of investment research and its author(s) is/are not subject to any prohibition on dealing in the relevant financial instrument ahead of the dissemination of the marketing communication.

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