Think about the events that transpired over the last two weeks. Now think about them in terms of the following two frameworks for how things could have gone.
- Fed comes out hawkish, guns ablazin’, Geert Wilders puts up a better-than-expected showing in the Dutch elections, the GOP health care bill moves forward
- Fed comes out timid with a dovish spin on the March hike, Wilders’ support wanes in Dutch elections, GOP healthcare bill fails
Framework one is dollar bullish. The euro dips on populism fears, a hawkish hike underpins the dollar by driving rate differentials wider as yields rise in the US while bunds are bid amid risk-off behavior in Europe, a positive outcome for Trump on healthcare bodes well for tax reform further underpinning the greenback.
Framework two is dollar bearish. The euro is buoyed by Wilders’ defeat, an uber dovish Fed pushes Treasury yields lower and UST-bund spreads narrow, further underpinning EURUSD, and the failure of the GOP healthcare bill and a protectionist slant to the G20 puts further pressure on the greenback.
Needless to say, framework two prevailed.
With that as the backdrop, consider the following from Barclays who is out with a trade idea for the week ahead.
USD: Trump cares
We see downside risks for the USD as Trump’s policy agenda gets challenged. In our view, the current administration is spending more political capital that initially assumed, limiting the likelihood of an aggressive implementation of the original agenda. If the lack of momentum prevails, we see the USD weakening particularly vis-a-vis developed markets such as JPY, EUR and GBP. In addition, as uncertainty remains high, the Fed will likely continue on the sidelines, limiting the room for short-end rates in the US to go up and support the USD. This week, there are no scheduled political events, as the health care reform bill has been pulled. The legislative disagreement signals a more complicated path for other reforms and is a blow to the administration, but it opens the path to start discussing other points in the GOP agenda. The week is light in data releases. We estimate that the PCE (Friday) price index rose 0.1% m/m and 2.1% y/y, with the core PCE price index up 0.1% m/m and 1.7% y/y.
EUR: Falling political risk to support appreciation amid still-high inflation
Declining French political risk is likely to support the EUR amid still-high CPI inflation. Indicators of short-term political risk due to the French election are decreasing, in line with our long-held view, and OAT-Bund 10y spread has decreased over the past few weeks (Figure 1). We forecast headline and core inflation to moderate slightly to 1.8% y/y and 0.8% y/y, respectively (Friday; consensus: 1.8% and 0.8%). Meanwhile, in H2, however, the EUR will be challenged by the reacceleration of economies in more advanced cyclical positions, while low underlying inflation could threaten market expectations of ECB tightening. The German IFO business climate index may also get attention this week (Monday; Barclays: 111.6; consensus: 111.1).
Ok. So who has a guess as to what all of this means in terms of where you should place your FX bets? If you said “the currency that is tethered to US policy and serves as a barometer of the market’s faith in the US reflation narrative,” you win a prize.
From Barclays again:
As Trump’s political capital gets consumed, we think that the USD might lose some steam as the prospects of a full implementation of the original agenda look weak. In the FX space, we see USDJPY as the highest beta exposure to the “Trump” trade.