USD Inflation Swaps and Expectations drag USD Higher, Asian Currencies weakening, Scandi Central Banks on Hold


The dollar is consolidating ahead of what should be a good 3Q16 US GDP figure tomorrow and it looks unlikely investors will want to bet against a dollar bull trend – at least in the short term. With the concept of central bankers allowing economies to ‘run hot’ emerging, inflation expectations are on the rise – e.g. the US 5Y5Y inflation swap is now up to 2.18%, the highest level since January. At least the Fed look set to respond to this, with USD swap rates ticking higher to keep real interest rates unchanged. The likes of the ECB and the BoJ will welcome the rise of inflation expectations with unchanged policy rates – and will hope that lower real rates will weaken their currencies. For today the US focus will be on the volatile DGOs which can provide insights on Capex. We suspect any dollar downside on any miss will be limited. DXY supported at 98.20/30.

We are back to the2014 regime where the US has the choice between a higher USD or higher bond yields. US data have come in on the strong side with this week’s Markit manufacturing and service PMIs exceeding expectations. A multiyear inventory adjustment has been completed and with the economy closing its post Lehman output gap, investment should pick up. In short, capital demand should increase, outpacing the increase of savings. Within a closed economy the cost of capital would increase. Of course, the US economy is open and not closed, connected with the rest if the world via trade and cross border capital flows. Our conclusion is that these types of flows should allow the USD to rise, particularly against low yielding JPY and CHF, over the medium term. Today’s market focus will be on the Scandi central banks.

US bond yields have risen again not only inspired by the release of better US data but also by sharply rising core EMU yields. The consequent steepening of the US yield curve works as a magnet for capital coming at this point in particular out of low yielding environments such as Japan and Switzerland. These types of flows support our bullish USD view. The global economy is still unbalanced. Global output gap differentials have widened as a number of G10 countries including the US either have closed or are closing their output gaps while in particular in Asia capacity use rates continue to fall.

Output gap differentials require the help of real effective exchange rate (REER) moves to act as a ‘equalising medium’. The REER has two components, namely the nominal FX and the inflation differential component. The problem is that this year the USD did the opposite of what would have been required to reduce global output gaps. The USD should have rallied against ‘output gap currencies’ mainly found in AxJ. Instead AxJ currencies rallied. The consequence will be inflation differentials now widening leading to diverging central bank responses; i.e. the Fed may hike and AxJ central banks may ease. Asian savings will make their way into US pushing the USD higher. Should for any reason global risk appetite turn lower then the anticipated fall of AxJ FX may gain early momentum. Shorting the KRW, SGD, TWD and the THB makes sense.

Dovish Riksbank but no rate cut. We still like buying USDSEK and expect it to cross the 2009 high at 9.30 in coming months. We expect EURSEK to cross the 9.90 level but prefer to trade SEK vs the USD. Riksbank speeches over recent months have shifted to be more explicit about being dependent on other central banks (i.e. the ECB) and putting less emphasis on financial stability risks emanating from a rapidly rising housing market. These points suggest a dovish Riksbank which is open to adding to QE purchases (we think potentially another 30bn announced this year), putting off rate hikes for longer and even carry out FX interventions (if really necessary and very low down on their list). Today the report should contain a discussion on the SEK, which for once has been going in the direction the central bank would like. As indicated in Ingves’ recent speech we don’t expect the Riksbank to push back against SEK weakness, just mark to market their KIX forecast. With very little expected by the market from this meeting but Swedish economic data weakening and large exposure to Brexit worries, we look to sell the SEK.

Norges Bank unchanged. Don’t expect the same excitement from today’s meeting as we got in September. There have been few data releases since then,all with a surprise to the downside such as CPI and industrial production. There is still potential for EURNOK to head towards 8.80 this year but we think the NOK rally should run out of steam next year from reduced fiscal spending. Already a larger proportion of the sovereign wealth fund is beingused for spending (around 3% of the fund) as there have been reduced oil related tax revenues combined with higher spending. Actually we expect the NOK to be more dependent on the path of oil for today, which has now broken below $50 due to market worries about OPEC supply not being reduced.