USD: Short-term FX models point to some initial downside risks - MUFG

Derek Halpenny, European Head of GMR at MUFG, notes that the modest correction weaker for the US dollar at the end of 2016 reversed modestly yesterday.

Key Quotes

“With market participants betting that the early flow of economic data will continue as it ended last year – showing the US economy strengthening while sentiment readings proving buoyant in the wake of the victory for Donald Trump in the election in November. While we have forecasts in place that indicate our belief that the dollar can gain further over the coming months, our analysis of short-term direction does point to the potential for some correction in certain currency pairs or at least a period of consolidation.”

“Looking at how spot is trading relative to interest rate spreads and looking at our short-term FX valuation models point to the US dollar being very well priced for continued good news on the economy. The 2-year yield spread has moved notably given the surge in the US 2-year yield to 1.21% - a level just below the high in December of 1.27%, which was the highest since August 2009. The move since Trump’s victory is close to 50bps and hence the data from the US will have to continue to show notable strength in order to avoid a correction lower in short-term yields. There will be plenty of data this week to test the level of US yields and any downside surprises in the US could see the EUR/USD rate correct higher ahead of Trump’s inauguration on 20th January.”

“However, we would argue that the dollar is more vulnerable against other currencies. Again based on our short-term models, the dollar has over-extended versus the yen, Australian dollar and the Norwegian krone. Any disappointment this week in the US data may well see these currencies out-perform.”

“That said, as stated above any move weaker for the US dollar will likely prove temporary and would be more a reflection of the large gains recorded since Trump’s victory in November. The US economy is certainly on a much firmer footing than at this point last year when expectations of Fed tightening faded rapidly and the dollar weakened notably. That is unlikely to be repeated this year and if anything the markets will ultimately begin to contemplate the possibility of the Fed raising rates at the March FOMC meeting. In that regard the minutes of the December FOMC meeting, released tomorrow, may prove interesting. But any US dollar weakness early this month should not be viewed as the start of a sustained period of dollar depreciation.”