After the Trump USD rally
After the Trump USD rally 2016 was a roller-coaster for markets.
A year ago investors were in panic about deflation. Back then, we took a contrarian view and argued that inflation was what could really surprise markets (Prepare to fight the central banks). Indeed, as the year progressed, a good case inflation scenario unfolded. Before the US elections, we argued that the good reflation scenario would continue, despite substantial risks (The rest of the year ahead and a preview of the year to follow). The market reaction following the US elections was even faster than we had expected. Having been right too early, we are now wondering what could surprise markets this year.
Markets could prove to be right and the USD could strengthen further. In real effective terms, the USD is about eight per cent above its 20-year average, but still eight per cent below its high of 2002. Although hedge funds are long the USD, real money remains short, relatively to positioning in the last 12 months (Liquid Cross Border Flows). We forecast USD/JPY at 120 and EUR/USD at 1.02 in 2017, but the risks are for an even higher USD in a positive scenario.
However, we do see substantial uncertainties this year. In the short term, we are concerned about US data in Q1, given negative seasonality in recent years. Negotiations for the US fiscal stimulus could be long and more difficult than markets currently expect. Trade protection remains a concern. Later in the year, Yellen’s replacement will become a key market theme. Beyond the US, Europe is facing political tail risks, with elections in France, the Netherlands, Germany and possibly Italy. We have also argued that markets are not fully appreciating the ECB constraints and the challenges ahead (The end of the Draghi cycle). Geopolitical risks depending on the policies of the new US administration could be another blind spot, with hard to predict market implications. Historically high equity prices and still low volatility suggest market complacency.
We remain bullish on the USD for the year, but see short-term risks. Following the strong USD rally, we closed our short EURUSD trade with a profit and remain long USD against JPY, AUD and NZD (Year Ahead).
Elevated US uncertainties make non-USD trades attractive to us. We have been arguing for EUR/JPY upside since September, as we believe that the BoJ has more credibility in easing monetary policy than the ECB. Assuming no tail risks in Europe, we like SEK, particularly against CHF. We stick to our contrarian year-ahead short EUR/GBP trade. And we are long vol in GBP/USD and EUR/USD. Chart 1: USD real effective exchange rate
By Bank of America Merrill Lynch