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USD: More upside correction to come
We are USD bears over the medium to long-term. However, near-term
market dynamics suggest the USD may do well in the short-term.
The USD index has staged an impulsive rally since late January,
on the back of an aggressive rise in US interest rate expectations.
Indeed, strong US economic performance of late and the continued
hawkish comments from Fed officials helped justify such readjustments
in expectations. Indeed, we have also raised our Fed
Funds Target Rate forecast - we now expect it to peak in Q2, at
5.00%, as compared with 4.75% by end-March previously. Together
with the fact that the longer end of the US Treasury yield curve has
yet to fully adjust itself accordingly, interest rate differentials still act
in favour of the USD in the near-term. Chances are that our medium-term
USD weakness call may take a while longer before materialising.
That said, with market expectations moving ahead of the actual Fed
moves, the futures market is now already close to pricing in a full
50bps hike from now until end-Q2/early Q3, and therefore we may
not need to wait until end-Q2 to see the peak of the current USD
rally. Indeed, one may argue that expectations can always overshoot.
Yet even if we do see that happening, such a phenomenon will be
temporary in nature, unless the fundamental picture suggests the
need for a fine-tuning in our core Fed rate scenario. In any case, our
belief is that once the dust settles over Fed expectations, USD
weakness will resume. By then, interest rate differentials will move
back in favour of those currencies that are still going for monetary
tightening (e.g. the EUR and the JPY). With no signs of resolution
in sight, structural concerns will also return to haunt the USD sooner
or later. Our full year view is for the EUR and the JPY to strengthen
and for commodity currencies to underperform against the USD.
JPY: Waiting for a major comeback
We are also bullish on Asian currencies, seeing them as the main
beneficiaries of our USD bearish story. They, for the most part, remain
very undervalued, as confirmed by their strong external surpluses.
Moreover, domestic demand and interest rates have been rising,
and the influence from portfolio inflows has been positive. Indeed,
that is exactly what we have seen since the turn of the year, but with
one eye-catching exception and that is the JPY, which has been
diverging from other Asian currencies up until early February. We
see a high chance that the JPY will play catch-up going forward.
With speculators currently sitting on large net short JPY positions,
and the increasing repatriation by Japanese institutional investors
and persistent inflows by foreign equity fund managers, we believe
that the JPY is well positioned to stage a strong comeback, both
against the USD as well as other Asian currencies. Here, any signal
from the Bank of Japan on the removal of the extraordinary
quantitative easing policy (something we expect to happen in H1
2006) could well kick-start this new trend. But for now, Japanese
retail investors are still eager to bring their money overseas, and
foreign speculators are still favouring JPY-funded carry trades (i.e.
short JPY and use it to fund long positions in high-yielding currencies).
Watch out for a reversal in the latter, as high-yielding currencies (in
Asia and elsewhere) could take a blow as and when the JPY tide
turns for the better. |
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Dollars & Sense
