USD subdued but solid in short/medium term - Natixis

Analysts at Natixis explain that after appreciating strongly in the last quarter of 2016, the US dollar has gone back on the decline against most currencies since the start of 2017, sharply underperforming emerging currencies, this against the backdrop of rising metal prices and the stability of the US 10-year interest rate around 2.50%.

Key Quotes

“This has fuelled a steady decline in volatility in the foreign exchange market, the CVIX pulling back below 9% to its lowest levels since 2014.”

“The dollar’s renewed bout of weakness stems from the Federal Reserve’s still cautious stance, from the announcement of protectionist measures by the new US administration and doubts over Trump’s capacity to push through his tax reform.”

“Our view is that expectations of a hike in the Fed Funds rate will heighten once the Federal Reserve knows more about Trump’s economic programme, as this factor has not been factored into its growth forecasts. We expect a further six hikes in the Fed Funds rate by end-2018, when the market barely prices in four further hikes.”

“The other factor that weighed on the US dollar was the outcome of the first G20 meeting under Trump. While the text relating to exchange rate commitments was unchanged, members reiterating their pledge to refrain from competitive devaluations, the G20 meeting could mark a turning point for global trade. The phrase referring to the members’ opposition to protectionism in all its forms was withdrawn, while Steve Mnuchin, the US Secretary of the Treasury, did not rule out a renegotiation of WTO agreements, stoking concerns of a trade war, notably between the US and China, that would penalise global trade.”

“One final negative for the US dollar was the decision to pull the American Health Care Act, which points to the Trump administration having the greatest difficulties pushing through its tax reform without tying this to a cut in public spending, as some members of the Republican Party are reluctant to agree to a further deterioration if the country’s public finances. Steve Mnuchin appears rather more optimistic, the Treasury Secretary expecting the tax reform to be passed as early as August.”

“As regards our scenario for the US dollar, the risk is that a situation will develop in which Trump will fail to get any of his reforms through Congress, these having contributed to the renewed optimism displayed by the equity markets and to the heightened expectations of a monetary tightening by the Federal Reserve. If the President in unable to convince members of his own party, this could trigger a correction by risky assets, in turn dragging down the US dollar, as was observed after the American Health Care Act (Trumpcare) had to be pulled.”