The USD Bull Market, USDJPY, USDSEK and the Emerging Markets

USD is back in playas the Fed prepares to hike rates later this year. Comments by the Fed’s ‘ultra-dove’ Evans suggest that a 25bp rate increase finds a broad majority consensus within the FOMC. Arguments brought forward are that the economy has closed its output gap, justifying a more moderate monetary approach, and that there is a capital misallocation risk that comes along when rates stay too low for too long. The fact is that volatility across various asset classes trades at exceptionally low levels while valuations have increased.

A rule of thumb suggests that rates should trade near levels of the nominal expansion rate of GDP. When rates and yields diverge from the nominal GDP expansion rate then financial asset valuations tend to rise. This is exactly whathas happened, but for good reason too. Fixed asset investment has remained weak, supporting the secular stagnation theory often explained by Larry Summers. Accordingly, real rates should stay lower for longer to support investment recovery. However, the price that loose monetary policy has to pay is steering more funds into financial assets, taking valuations even higher.

It is not only the Fed. The USD has broken out of its consolidation pattern developed since March. Long-term DM sovereign issuance activity has helped steepen yield curves and with DM labour markets tightening and key raw material prices moving higher, investors seem to conclude that global deflationary pressures have abated somewhat for now. Steeper DM curves are pushing low-yielding currencies down and the USD up. Over the past couple of weeks, USDJPY has gained almost 4%.Further gains should be in store.
DM yield curve steepening may have a profound effect on EM capital flows. High valuations of riskless assets have been driving equity and other higher-returning assets up, which has supported EM inflows into AxJ, in particular. Should bond yields break higher from here, then previous inflows are likely to turn into outflows. High-yielding, foreign-capital-requiring currencies are likely to weaken (ZAR, TRY and COP). IDR and BRL are likely to continue to outperform, in our opinion.

Bearish sterling positioning is extreme and a corrective rebound should soon set in, with the 1.26 area offering a selling opportunity, in our view. Indeed, we have revised our GBP projections moderately lower as the UK heads toward Brexit. Our economists see a 70% probability of the UK losing full EU market access. Investment uncertainty reduces inflows and with the economy heading toward Q1 weakness, we think GBP has not surpassed its point of biggest vulnerability, yet. For GBPUSD, we target 1.21 for the end of this year and see a low of 1.15 in 1Q17.
The destiny of the SEK is closely linked to GBP as Sweden has large UK trade exposure. Sweden’s growth outlook has declined over recent months, now underperforming EMU. While the technical GBP rebound may provide SEK some temporary relief, we use this USDSEK retracement to get long. Elsewhere, we sell the ZAR, KRW and the SGD against the USD.