From MS' weekly 'Pulse' reseach piece on why the USD will keep falling
In brief:
On global growth:
- Continued global economic strength and low volatility have remained asset price supportive
- Savings surpluses in Asia (ex China) and Europe
- Expansionary monetary policies adding further support via ample liquidity.
- Nominal growth continues to rise relative to funding costs, creating strong incentives for leverage and yield-enhancing trades.
On liquidity and carry:
- DM bond yields are unlikely to rise materially without central banks increasing their tightening efforts or global savings falling
- The Fed's transparent, gradual tightening approach parallels the 2004-2006 cycle, though over that period, the real 10Y rate had to rise to 2.5%, 200bps above current levels, before the carry trades reversed
- The EM-US real yield spread has rarefy been this supportive, and thus the EM rally is likely to continue.
The USD should act as the main funding currency along with the CHF
- we argue the EUR and JPY no longer qualify as funding currencies
- Back-end rates now matter more for markets than front-end rates, and long-dated yield differentials should favor EUR and JPY
- QE and tight fiscal policies have reduced foreign holdings of EUR-denominated assets, but foreign ownership of USD assets has actually gone up
- If US rates rise (against our expectation) or US assets underperform, the foreign investors in these assets may begin to rethink their overseas exposures
- Thus, US rates and USDJPY may no longer rise in tandem.
Trading
- Unlike Japan's current account surplus, which is largely driven by the income balance, Switzerland's current account is largely a function of trade. This surplus has largely been recycled back into low-yielding domestic assets, causing CHF strength. Rising European returns are leading to a change in this process, suggesting to us CHF weakness. This week, we buy NOKCHF and sell GBPJPY.
