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The USD staged a sneaky rebound in February :

The performance of the USD in the month of February has been remarkable, to the extent that it was strong and also very localized. Broad USD indices have rebounded from the lows of late January but this strength has been primarily a G10 story, as EM currencies continue to outperform, supported by rising terms of trade and generally high appetite for risk assets. The localized nature of the USD move reflects in our view mostly a shift in market focus on the French elections and, to a lesser extent, on rising policy divergence expectations following Fed Chair Yellen’s testimonies to US Congress last week. On the European front, the widening in French spreads vs core yields has likely contributed to ongoing strength in German fixed income assets, and as a result in a tightening of EURUSD’s interest rate differentials against the USD. As for the Fed, markets have reacted to the combination of the upside surprise in CPI on 15 February and of remarks by Fed officials suggesting that the March meeting is still “live” by pricing in a higher probability of a hike at the upcoming FOMC meeting. Lack of clarity on fiscal policy remains the main impediment for a more transparent set of expectations about the FOMC’s intentions – a common refrain to the bulk of the commentary by Fed officials over the past few weeks. This could however change between now and 15 March. On 28 February President Trump will address a joint session of Congress. The address is fairly common for newly inaugurated Presidents, in lieu of the annual State of The Union speech. There is no assurance that the 28 February address will feature any details on the tax and trade policy front, but it is definitely a possibility. We continue to view the possibility of a BAT announcement as negative for EM FX and more broadly supportive for USD. In this issue of the FX Compass we revise our USDMXN forecast lower to 19.00 in 3m and 22.00 in 12m (prev 23.00 and 25.00) in reaction to yesterday’s intervention announcement. We turn neutral on the NOK, revising our EURNOK forecasts higher from 8.70 to 8.85 in 3m, and from 8.50 to 9.00 in 12m. In EM, we cut our USDTWD forecasts, and restate our bullish case on the Russian rouble.

Macro Overview: Quiet Riot The performance of the USD in the month of February has been remarkable,

to the extent that it was strong and fairly localized. All broad USD indices, including the one produced by Bloomberg shown in Figure 1, have rebounded from the lows of late January. This strength has however been primarily a G10 story, as EM currencies continue to outperform, supported by rising terms of trade and generally high appetite for risk assets. This mixed performance is reflected in the convergence in average implied G10 and EM vols, with the latter now close to pre-US election lows (Figure 2).

The localized nature of the USD move reflects in our view mostly a shift in market focus on the French elections and, to a lesser extent, on rising policy divergence expectations following Fed Chair Yellen’s testimonies to US Congress last week.

On the European front, the widening in French spreads vs core yields has been significant in the past few weeks (Figure 3), and likely contributed to ongoing strength in German fixed income assets and in a tightening of EURUSD’s interest rate differentials against the USD (Figure 4). Our economists remain of the view that a Le Pen victory is very unlikely at the second round, despite rising momentum in the polls, and highlight how the strong economic outlook could reduce the likelihood of a broad protest vote (link). Markets seem to agree on this view, as suggested by the divergent pricing in Euro crosses. Demand for 3m downside EUR protection appears to have picked up significantly in EURUSD and EUCHF since the May 7 election deadline entered the 3m tenor, but remains elusive in high beta EUR crosses such as EURSEK and EURHUF (Figure 5). The localized nature of the pricing is reflected in the still low level of implied EUR correlation (Figure 6)

As we highlighted last week with regards to CE3 currencies, we see potential for the pricing of French election risk to broaden in the weeks ahead, if Le Pen’s deficit in the polls were to tighten further. Against USD, CHF and GBP we would expect this to translate in further EUR weakness, as investors are likely to react to increased political risks with stronger demand for safe assets. Our 3m forecasts of 1.03 in EURUSD and 1.055 in EURCHF reflect this view. On the other hand, we see less potential for a clean cut move in EUR crosses such as EURSEK and the CE3 complex, in the light of the likely negative impact on risk appetite. Furthermore, Brexit dynamics will likely continue to dominate EURGBP price action as we near the March deadline for triggering Article 50. As such, we see limited potential for a significant pick-up in EUR implied correlation in the coming weeks. On the other hand, we see better scope for a pick-up in implied USD correlations in the next few days, ahead of the FOMC’s 15 meeting and of President Trump’s joint address to Congress on 28 February. As for the Fed, markets have reacted to the combination of the upside surprise in CPI on 15 February and of remarks by Fed officials suggesting that the March meeting is still “live” by pricing in a higher probability of a hike at the upcoming FOMC meeting, which now stands at approximately 38% (Figure 7). In FX space this has translated in the emergence of a slight “kink” in EURUSD and USDJPY vol curves, corresponding to the timing of the March FOMC meeting (Figure 8).

The release of the minutes from the previous FOMC minutes today could offer markets some insight on this front, even though there is a risk that markets might focus instead primarily on the committee’s discussion of balance sheet normalization dynamics, as suggested by our US rate strategists. Lack of clarity on fiscal policy remains the main impediment for a more transparent set of expectations about the FOMC’s intentions – a common refrain to the bulk of the commentary by Fed officials over the past few weeks. This could change between now and 15 March. On 28 February President Trump will address a joint session of Congress. The address is fairly common for newly inaugurated Presidents, in lieu of the annual State of The Union speech. On 10 February President Trump stated that the administration would be revealing details about its tax reform plan within the following two to three weeks. There is no assurance that the 28 February address will feature any details on this front, but it is definitely a possibility. FX markets in particular will be very keen to know whether the border adjustment tax measure that was presented in the Brady/Ryan “Better Way” proposal  will be part of the administration’s agenda. This proposal has been portrayed in financial news as strongly opposed by large swaths of Republican Congress, and has been thereby discounted as unlikely to succeed by markets, as suggested by the strong performance of emerging markets assets. An announcement suggesting that the administration will indeed pursue some form of border adjustment taxation could provide the catalyst for an increase in uncertainty, in our view, with likely broad positive implications for the USD at least in the near-term. We continue to flag this as an ongoing risk that informs our long-term USD forecasts.

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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