FX Views:How far can the Dollar Reset go

1. After the sharp rise in 2014, the Dollar went into a holding pattern from March2015, when a series of dovish shifts from the Fed prevented it from moving higher(Exhibit 1). These dovish shifts culminated in the R-Star narrative, which we saw asan intellectual framework to justify “lower for longer” and, basically, “Dollartargeting.” In our last FX Views (“Dollar Reset”, FX Views, November 10, 2016), weargued that the US election represents a “reset” for two reasons. First, thepossibility of meaningful fiscal stimulus in an economy where slack is close to zeroraises upward pressure on inflation, as Chair Yellen and NY Fed President Dudleyacknowledged this week. Second, President-elect Trump can make a number ofappointments to the Fed in fairly short order, which could shift the reaction functionhawkish. Both things have pushed front-end interest rates up (Exhibit 2), and theDollar is now near the top of the range it has traded in since March 2015. As in 2014,when the Dollar was on the move, the question is now how much further it can goin the near term. Federal funds futures are one lens through which to look at this.They have obviously moved a lot, but the market in our view is still catching up to thechanged landscape. The market is pricing 64bps in tightening through 2017, wellbelow our US team’s forecast of 100bps. More importantly, through end-2019themarket is pricing 130bps, or just over five hikes. This strikes us as low and points tofurther upside for the Dollar, including in the near term. We are through our year-endtargets for EUR/$ (1.08) and $/JPY (108), which were controversial just a short timeago, and the risk to our 12-month forecasts – 1.00for EUR/$ and 115for $/JPY – isnow firmly in the direction of more Dollar strength. We also discuss idiosyncraticthemes. Sterling downside has fallen out of favor, but we think remains one of themost actionable themes. This is why we went short Sterling and the Euro againstthe Dollar as one of our Top Trades for 2017(“Top Trade Recommendations for 2017”,Global Viewpoint, November 17, 2016). Another theme we like is short AUD/CAD. Theincoming administration is likely to take a more favorable view of the Keystonepipeline, which should shrink the discount of Canadian crude to WTI. This couldcause the Canadian Dollar to outperform the Australian Dollar. Finally, we went shortthe RMB as one of our Top Trades. While this is partly a Dollar play, there isasymmetry from the fact that a rising $/CNY fix could cause capital outflows to pickup, even before taking into account potential trade frictions. We this week revisedour forecast for the $/CNY fix to 7.00, 7.15and 7.30in 3-, 6- and 12-months, reflectingour more bearish RMB view since the summer (“No Easy Fix to the RMB Problem”,FX Views, June 2, 2016).