USD Index, US Rate Differential, EURUSD, USDJPY and NOK

The Fed’s broad USD Index surpassed its January high on Friday and is now setup for further gains, marking the next leg of the USD supercycle. USDJPY is leading the way this morning, which we expect to continue as the pair has broken through the July high around 107.50, seeing little resistance until beyond 110. We believe that the DXY should underperform the broad USD index as its largest constituent, EUR, is being supported by real rates, leaving the USD rally to be concentrated on Asian currencies. The US-world nominal rate differential continues to head higher, with focus now on real rates and their potential impact on risk appetite. This week market focus will remain on debating the potential policies from the newly elected US president and on Fed Chair Yellen’s testimony to the economic committee on Thursday.

 Trump continues to make senior appointments to his cabinet. Last night Reince Priebus was named as chief of staff and Stephen Bannon as a chief strategist and senior counsellor. The press is reporting that these appointments suggest that Trump is trying to take views from all sides of the Republican party. Equity investors may now try to put probabilities on each detail of the suggested policies made during the campaign, such as which parts of the Affordable Care act and the Dodd-Frank act could remain. For FX investors, however, it will be about the expected growth and inflationary boost from these policies and whether they will spur the Fed to raise rates faster next year.

Crossing through a previous high at 107.49, we foresee an initial target of 112. We have often said that higher inflation expectations or steeper yield curves would have been required for USDJPY to turn around. However, the reason for steepening didn’t need to come from the Japanese side. The correlation between global bond markets is high, meaning the US 2s10s curve hitting the highest level this year has spilled over into the Japanese curve steepening too. Steepness has been focused on the shorter end of the curve.

As the market prices in a faster pace of Fed hikes due to expectations of higher growth and inflation, there could also be debates forming about whether the ECB will need to extend its QE programme beyond next year. The US 5y5y inflation swap has hit the highest level this year at 2.47%, allowing the eurozone’s equivalent measure to also rise to 1.55%. We expect EURUSD to find support around 1.07, with the January low of 107.11 being key.

 Tomorrow will see the release of Norway’s 3Q GDP, which we expect to be relatively weak as industrial production data have not picked up recently despite the global rise in manufacturing PMIs and commodity prices. Our economists see headline GDP at 0.1%Q and mainland GDP at 0.4%Q. We will be focused on what proportion of growth has been generated by fiscal spending, as government spending is expected to decline next year, presenting a downside risk for NOK. We will also be looking for any signs of Brexit-related weakness. We see upside for USDNOK, which is still loosely correlated with oil and is now breaking through upper resistance at 8.40. We still think the market is long NOKSEK, which failed to break through 1.10, so position adjustment may also put downward pressure on NOK.