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What remains to be discussed is the significant USD strength. There is an easy explanation, namely the surprisingly strong US GDP growth figures released on Friday (Q3 2017: +3% QoQ in annualized terms; the forecast was c. 2.6%). These figures seem to imply that the Fed will almost certainly hike the Fed funds rate and thus support the USD. Still, the explanation has several flaws.
First, the USD already firmed considerably on Thursday. And second, the GDP figures have not affected the market-based long-term inflation expectations, which remain in the no-man’s land above the lows of 2016, but significantly below the normal levels of before 2014. But if the market does not expect strong growth to fuel inflation, then it probably does not expect growth to lead to rate hikes either.
Lower unemployment, the other important factor in the rate model, is unlikely to drive Fed expectations either, as the US has been enjoying full employment for some time now.
We now know the ECB will extend its QE program from January to September (at least) with purchases set at €30bn per month, and it also announced that it will continue to buy sizeable amounts of corporate bonds. The early market reaction saw sovereign bond yields drop and credit spreads inch slowly tighter. The implications for credit are very positive for the coming months.
The dollar revival that has been in train since late September gathered pace this week as the Euro sold-off sharply following a dovish ECB. The USD TWI has now gained close to 5% from its YTD lows, but that has oddly not impacted vol or risk-reversal pricing to any significant degree so far outside of select EM pockets experiencing idiosyncratic turbulence.
Indeed, VXY is almost a full vol lower since the dollar rally began, in part due to the passage of the event-laden few weeks in September (ECB, Fed, debt-ceiling), partly because of the day-weight impact of the quiet December holiday period, but most importantly because USD put demand from leveraged investors – particularly vs. EUR and EUR-correlates that had driven the Q3 vol uptick – has now receded.
