Dovish Yellen May Be The Best Outcome For USD - Credit Agricole

Risk aversion remains deeply entrenched ahead of the Yellen testimony today. USD remains the underperformer among the majors with EUR, CHF and JPY quite supported. The market thinking seems to be that whatever the message that Yellen delivers tomorrow, the USD will get hurt one way or another. Indeed, dovish comments by the Fed chair aimed to sooth market fears should erode USD's rate advantage broadly and weigh on the currency. Worse still, any indications of growing Fed concerns about the global economy could fuel more market anxiety and boost the performance of the safe haven EUR, CHF and JPY against USD.

At the same time, if Yellen were to stick to the Fed's constructive view on the US economy and highlight that the next move for the Fed should still be a hike, this could undermine investors' appetite for risk. This outcome could be supportive for USD against the less liquid risk-correlated currencies. Given the extent of the risk aversion at present, however, a more constructive message could add to concerns that the Fed is falling behind the curve and may be forced to even ease again before long if growth outlook continues to deteriorate. The USD could then suffer on the back of both growing risk aversion and persistent erosion of its rate advantage.

Our view is somewhat more nuanced. We think that Yellen will acknowledge the latest tightening in the global financial conditions and highlight that the Fed will pause in its tightening cycle to help markets recover. At the same time, the Fed Chair will stress her confidence in the ongoing US recovery. Indeed, with the US labour market now very close to full employment, the economic recovery is increasingly dependent on wage growth as well as the continuing gains in the US housing market. There should be now less reliance on the wealth effect from the US stock markets and thus less of a threat to growth from the persistent risk off abroad. The Fed thus need not worry as much about the outlook, but will nevertheless signal willingness to support global markets.

How will USD respond to a balanced to somewhat more dovish statement by Yellen? We think that this maybe the best possible outcome for USD. Indeed, a signal from Yellen that rates would remain close to their levels for longer will only confirm but unlikely exceed the already rather dovish market expectations. There is therefore less scope for USD-underperformance against higher-yielding G10 currencies on the back of that. In addition, a potential risk recovery on the back of the comments could support market sentiment and help USD consolidate against EUR, JPY and CHF. That said, we are conscious of the risk that any rebound in risk appetite on the back of Yellen could prove tentative with investors still worried about China and global banks.

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