JPM Key drivers of USD view

JPM Key drivers of USD view

 Forecast changes this month are minor, and focused
on commodity currencies. Q1 targets for EUR/USD and
USD/JPY are unchanged (1.30 and 76), but forecasts for
AUD/USD are revised from 0.98 to 1.04, NZD/USD
from 0.72 to 0.80 and USD/CAD from 1.04 to parity.

 The last round of forecast changes published in
November 2011 envisioned USD strength versus all
currencies but the yen in Q1 2012 as the sovereign crisis
intensified. Spring was expected to mark the dollar’s
inflection point as the ECB/IMF delivered funding for
the periphery in exchange for structural reform (passing
supply-side liberalization would have sufficed, since
these policies won’t deliver growth in 2012). From early
Q2, the dollar was expected to decline versus all
currencies (including the euro) for the traditional reasons:
zero-yielding currencies of current account debtors like
the US have little value outside of a financial crisis. The
US growth acceleration relative to Europe wasn’t very
relevant until US cash rates rose, an event which is still a
few years away. Neither did we
consider ECB balance sheet expansion a source of USD
upside since the policy does more to reduce global credit
stress (USD-negative) than it does to move short-term
US –EU rates spreads (euro-negative). See also Euro on
page 6.

 The ECB delivered liquidity sooner than expected and
not exactly as we envisioned it (a 3-yr repo rather than
asset purchases), but the effect is the same: the dollar is
falling across the board (chart 1), even versus the euro.
So much for the regime change theory which made the
rounds in late 2011. Such a permanent correlation flip
between the dollar and stocks could come in a few years
when/if the dollar in a high-yielder (since the US funds
itself more on fixed income than on equities or M&A),
but it is not an event for 2012.

Risks to the view
 Risks to the dollar are balanced this quarter since the
ECB’s LTRO significantly diminishes the tail risk of a
European bank or sovereign liquidity crisis. The forecasts
still do not show much trend for the year since event
risks inhabit every major region. In Europe, the Greek
debt swap may not attract sufficient investor
participation. In the US, Congress may fail to renew the
payroll tax holiday, thus imperiling an only-average
expansion. In China, the country’s underlying run rate
still isn’t apparent given data distortions from the
Chinese New Year. Volatility looks too low at roughly
10% on VXY Global, and a move toward the 12% to
15% range we envision for 2012 as event risks
materialize would also be associated with fits of USD
strength. Moderate USD weakness (3% trade-weighted)
and above-average volatility are still the base case.

J.P. Morgan forecasts

Short-term valuation model
 A short-term cyclical model linking the trade-weighted
dollar to global rate spreads and equity volatility suggests
that the currency is about 1% expensive. This slight
overvaluation is largely due to the dollar’s strength
versus European and Latin currencies since the 2011
deleveraging. It represents a significant reversal from the
dollar’s 5% cheapness in mid-2011, before global stocks
sold off and the dollar rallied versus all currencies but the
yen.

Long-term valuation model for USD
 A longer-term structural model regressing the real
effective exchange rate on quarterly variables such as
debt levels, terms of trade and productivity differentials
suggests that the currency is about 6%, cheap. This
misalignment is far smaller than the dollar’s massive
overvaluation in the late 1990s (+20%) or its extreme
cheapness before Lehman (-17% from fair value).

Technicals
 The broad USD weakness since the start of the year
(except vs JPY) suggests a growing risk that a short term
consolidation phase is underway. This is in line with the
effective test and hold of a number of important support
levels within G10. Importantly, the DXY held the
81.33/44 resistance zone which includes the double top
from Nov’10/Jan’11, while the JPM USD index
(JPMQUSD) once again reversed from the critical 83.00
medium term range highs. Moreover, EUR/USD
effectively held the key 1.2600/1.2588 medium term
support area (includes the 76.4% retracement of the rally
from the 2010 cycle low). While the persistent
overbought USD setup suggests additional retracement,
there is not enough evidence to suggest the medium term
trends are complete. January weakness looks like a
correction rather than a turn.

 The key test for the DXY enters at the 79.24/70.87
support area. These levels represent the late-December
low as well as the 38.2% retracement of the advance
from the October low and will define whether a deeper
corrective phase is underway. Breaks would target the
78.00/77.40 zone. For the JPM USD index, the
80.88/80.55 zone will be the key short term test with
violations confirming a test of the critical 79.54/79.00
zone which should define whether a more sustained USD
bear trend is underway.