USD: Fighting the Flows for Now

USD: Fighting the Flows for Now

Although we remain constructive on USD for year-end, our view is being challenged in the short term. A combination of crowded USD net longs, temporary stabilization in the European crisis, easing in EM monetary policy and an improvement in risk appetite are putting USD on the back foot. We suspect that the short-term retracement has more technical room to run, given extended positioning (see Exhibit). That said, we do not believe that the fundamentals have changed to merit a sustained USD decline. In particular, the progress in the EU is not occurring at a fast enough pace to justify EUR/USD above 1.30. We believe that current levels are good opportunities for shorts – we forecast the pair at 1.15 by year-end.

With USD largely still a counter-cyclical currency, we need for risk appetite to be challenged again to see a trend reversal. We believe that the most likely catalyst will still come from Europe. The ECB’s LTRO and SMP purchases have temporarily bought policy-makers more time, but markets will soon become anxious again with the lack of a long-term fiscal solution, in our view. Meanwhile, the PSI negotiations remain unsettled in Greece and the chances of a Portuguese default are rising. We suspect that the safe haven bid will return to USD as the European situation deteriorates in the coming months. Capital flows out of Europe are likely to go to sources with deep liquidity, aiding USD.

Domestically, the US data have been more mixed lately. We believe that growth this year will moderate, and remain at a lukewarm pace of 2.2%. This makes the US the outperformer in the major economies. Yet, the still-high unemployment rate combined with declining inflation also makes QE3 a likely prospect in 2Q12. This could put some near-term pressure on USD, but we do not believe that the impact will be significant. The market has shown declining sensitivity to each round of QE, and with others around the world also engaging in money printing, USD should not get singled out .

The main risk to our USD call is an extension of the ongoing risk rally. If global growth proves stronger than our forecasts, or the eurozone problems are solved faster, this would keep USD weaker for longer. We do not see this as a likely case at this juncture, believing that we are close to a trough in the USD retracement.