[AndrewWoo]

The unwind of overweight positions in relatively defensive US fixed income and equity markets in favor of allocations to those with greater sensitivity to global growth is now well advanced. The rebound in inflation break-evens and the narrowing in credit spreads both suggest markets are no longer pre-occupied by deflation risk and de-leveraging. Strong capital inflows into EM have restored the process of EM central bank FX reserve accumulation and subsequent diversification selling of USD, forcing some to revise up the EUR-USD profile. It should, however, dissipate somewhat as capital inflows to EM slacken from their recent pace.

Positioning in FX and fixed income markets seems to have already adjusted to a more pro-risk/less defensive stance, but real money equity portfolio managers appear a little more cautious. As such, the USD could remain under pressure a little longer, though some expect this overall positioning adjustment theme to lose force over the early part of summer. At this point the correlation between the USD and economic data surprises could flip, especially should markets begin to associate better data with a credible threat of Fed tightening.

Sound policy and a strong USD are rational policy choices
“Rebalancing” or the much reduced US current account deficit means that material USD weakness must now come via an adjustment in the stock of foreign holdings of US assets rather than from financing flows. This could occur if major holders of USD assets seriously question the Fed’s commitment to price stability and/or the ability of the Obama administration to bring the Federal budget back toward long-term balance. We do not think policymakers will allow this theme to gain any real traction. In fact a strong pushback against this was evident in recent speeches from US Treasury Secretary Geithner, Fed Chairman Bernanke and Atlanta Fed President Lockhart. Buttressing policy credibility is in everyone’s interest as the limits to policy stimulus have arguably been reached. More fiscal largesse would arguably result in a steeper yield curve via higher risk premia on sovereign debt. More QE could result in a steeper yield curve via higher inflation expectations. As such, talking about exit strategies, targets for inflation and fiscal consolidation, etc. are supportive of the economy as well as the USD.

A strong USD is also in the US interest. Neither the Federal Reserve nor the Obama Administration will want USD weakness to develop as a constraint on the room to maneuver domestically due to higher import costs. Expressions of support for the USD from both EM and key European policymakers have recently started to emerge. It is also not expected that material “stock” diversification out of USD by EM central banks given the lack of viable alternatives.