FxWirePro: What drives bullish dollar again in H2’2017 – low beta formats

The US dollar index closed Friday unchanged on the day. The H1’2017 turned out to be one dominated by USD weakness, and the outperformance of EM carry, an outcome expected by few at the beginning of the year. The broad slide in USD intensified over the past month and the trade-weighted index delivered has weakened by 2.4% over the past month, its largest monthly drawdown in fourteen months.

For now, at mid-year, the USD is materially cheap on rate-spread models, money market underpricing of the Fed is at an extreme, and US relative cyclical underperformance is reversing.

In the upcoming weeks we highlight four themes that will drive FX in 2H:

1) The relative pace of policy normalization

2) China rebalancing and commodity supply risks,

3) Political risk, and

4) EM fundamentals and carry. 

We also review four old and new wildcards:

i) The risk of more persistent disinflation,

ii) Washington fiscal uncertainty in September,

iii) Fed balance sheet normalization, and

iv) Trade protectionism headline risks.

Trade recommendations:

Portfolio themes are unchanged. Keep exposure to FX carry, albeit in low beta format (short NZD/BRL, long TRY/ZAR) where valuations and idiosyncratic factors are compelling.  Cheap valuations, improving growth and low US rates keep us long USD but only vs. other DM (long DXY).

Long currencies with strong idiosyncratic drivers (long ILS on strong external balances, long CZK on policy normalization and valuations).