The key feature of the foreign exchange markets has been the USD’s lack of follow through after the hawkish FOMC. Indeed, while the USD has traded largely flat against the majors, EM currencies have rallied sharply since the FOMC meeting. A basket of the ‘fragile five’ currencies against the USD, for instance, is up nearly 6% on the year in spite of the wobbles at the beginning of the year. The price action in the majors is much more muted against the greenback but AUD and CAD have performed quite well over the past month. We suspect there are three key drivers of this price action that are likely to reverse over time.
First, US data surprises have failed to provide the support needed for the US rates market to accept the Fed’s hawkish message. The 2-year yield only rose 3bp since the last FOMC meeting and still remains 7bp from the high in September 2013.
Next, news that a Chinese stimulus package is in the works has buoyed risk appetite and helped lift both the EM and commodity linked G10 currencies. We think the potential of this package is overstated and at the same time is counter to the rebalancing process that policymakers have pursued. As such, we think price action linked to a large-scale Chinese stimulus package is buy the rumor, sell the fact and the impact will begin to fade over the coming weeks.
Third, geopolitical tensions between Russia and Ukraine are stabilizing. The combination of these major macro themes have led to lower foreign exchange volatility and a search for yield. What’s more, the policy action taken by some EM central banks have increased the carry return, boosting capital flows to higher-yielding EMs. In the near-term, we think payrolls will be a deciding factor about whether this price will persist or not. In the G10, in particular, we note the EUR is quite ‘rich’ to cyclical factors, such as the 2-year swap, commodity prices, the S&P and the Vix.
The residual of the model suggest EUR/USD fair value is below 1.35. Looking ahead, we look for a reversal of some these themes to boost the greenback in H2.