[ForexNews]

The outlook for the USD is gradual appreciation amid volatility. The explanation for this is that FX markets cannot go directly from buying USD on fears of policy tightening to buying USD on risk aversion. In between these two states is a “middle-way”. Middle-way conditions are economic recovery accompanied by limited but rising inflation risk and a low threat of policy tightening. The USD weakens in such an environment as it becomes a funding currency for risk asset positions and the process of current account contraction is interrupted by rising imports. We believe that the middle-way has become very narrow and is flanked on one side by deflation risk and by inflation risk on the other side. The recent wake-up call for risk assets and the saving grace for the USD has been that the Fed emphasized monetary accommodation will be reduced should economic recovery gain traction to the degree that was being priced into many asset markets. As long as the Fed does not let its guard slip on inflation then the
USD can, once the initial positioning adjustment is complete, rally in a right of middle-way (recovery focused) world. Policy credibility is therefore pivotal.

[ForexNews]

The unwind of 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 preoccupied 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. However, this should dissipate as capital inflows to EM slacken. As a result, some expect the USD negative positioning adjustment theme to lose force over the summer. At this point the correlation between the USD and economic data surprises could flip should markets begin to associate better data with a credible threat of Fed tightening.

[ForexNews]

Material USD weakness must now come via an adjustment in the stock of foreign holdings of US assets rather than from a lack of financing flows given the much reduced current account deficit. This could occur if major holders of USD assets 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. Analysts do not think policymakers will allow this theme to gain traction. A pushback is already evident in recent US Treasury Secretary Geithner and Fed Chairman Bernanke speeches. Buttressing policy credibility is in everyone’s interest as the limits to policy stimulus have 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 now, as well as the USD. A strong USD is also in the US interest, as US officials will not want USD weakness to develop as a constraint on their room to maneuver. Analysts do not expect material “stock” diversification out of USD by EM central banks given the lack of viable alternatives.

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