USD: Late 2017 looks more fertile for gains - Westpac

Richard Franulovich, Research Analyst at Westpac, explains that their G10 FX model has swung from outsized USD shorts back to bullish this week, thanks entirely to a formal reversal in our US data surprise index.

Key Quotes

“The rise in our surprise index has been modest but enough to push it back above the lower one standard deviation threshold, a trigger that a bigger reversal in the complexion of the US data is nigh. Financial conditions are remarkably easy too and that has been a solid leading indicator for our US data pulse, flagging a potentially strong turnaround in the complexion of the US data. See slide one.”

“But, there are a number of hurdles to USD gains in Q3. Q4 appears to be a much more fertile environment for USD gains.

• EUR is unlikely to correct meaningfully lower until the ECB makes a formal tapering announcement. The ECB has three meetings left this year: Sep 7, Oct 26 and Dec 14. Draghi said an announcement could be made in “Autumn”, which puts the spotlight on Oct 26. The USD’s price action during the 2013 taper tantrum is instructive. Chair Bernanke first uttered the possibility of tapering on 22 May 2013 and the Fed formally announced tapering at their 18 Dec 2013 meeting. The USD and US yields were well supported over that entire interim period and saw mild further gains into Jan 2014. But, with tapering all but priced in by then, US yields and the USD fell from Jan to May 2014. EUR and bund yields may well behave similarly.
• The CBO and Bipartisan Policy Center estimate that extraordinary measures that are being used by Treasury to keep the US below its debt ceiling will expire early to mid-October. Separately a continuing resolution to fund US government spending expires Sep 30 and failure to pass a new resolution will see key operations shutdown Oct 1. Even though Republicans control all the levers the party is fractured between a staunch conservative House wing and mainstream moderates in the Senate. The conservative wing may well repeat past tactics and demand spending cuts in exchange for a vote in favour of raising the debt ceiling. The White House appears to be just as divided too: Budget Director Mulvaney has called for spending cuts to be attached to any debt limit increase also but Treasury Secretary Mnuchin has repeatedly called for a clean increase in the debt limit.
• Seasonality is much more fortuitous for the USD in Q4 than Q3 too. Q3 is usually a checkered one for the USD: it has shed ground in 6 of the last 10 third quarters. But, the USD has risen in 8 of the last 10 fourth quarters.
• Washington will be pivoting toward tax cuts and tax reform in Q4 too and while divisions inside the Republican party could ultimately impede any meaningful progress, Trump reflation hopes should nevertheless see a fresh burst of energy early in the piece. An aggressive timetable has been laid out by officials that sees a bill passed in both the House and the Senate before the year is out.”    

“The USD is likely to struggle even with a potential tailwind from firmer data given that the ECB has yet to make a formal tapering announcement and with Washington gearing up for another showdown over the debt limit in Sep/Oct. Later Q4 looks much more fertile ground for the USD – by then these key event risks will have been negotiated, seasonals are much more supportive and Trump reflation hopes will enjoy a fresh burst of energy as Washington pivots towards tax cuts.”