USD outlook : RBC

RBC Capital Markets notes:

1-3 Month Outlook - Renewed upside momentum

As the focus has shifted from the weakness of the US economy in Q1, to the strength of the rebound in Q2, so the bullish-USD trend started to reassert itself in late-May and DXY has retraced more than half of the losses since the mid-March peak. Although the improving US data have clearly been a factor in the turn higher in USD, the movement in rate expectations has so far been very modest. 

The US forward curve (Figure 1) remains priced for a later start to the US tightening cycle than our economists' forecasts imply. Forward Fed funds are only a full 25bp above recent realised rates in January 2016 - four months later than the September 2015 hike we expect. If the monthly indicators continue to come in consistent with a 3%+ annualised increase in Q2 GDP, we expect a repricing of US rates to drive another significant leg higher in USD. 

Indeed, with rate expectations outside the US unlikely to fall much further from here (in fact our economists' forecasts have DXY-weighted 2yr swaps around 10bp higher by year-end) a material rise in US forward rates is becoming a necessary condition for a higher USD, not just a sufficient condition. That said, much reduced investor positioning since the turn of the year has lowered the hurdle for rising US rate expectations to push USD higher. 

Our positioning indicators for EUR and JPY, based on FX managers' return correlation to spot FX  suggest long USD positioning against EUR and JPY is its least extended for a year - consistent with much reduced longUSD positioning on the IMM and a significant reduction in the premium for USD calls over puts against most of the majors. Our forecasts imply DXY rallying back to around 100 over the next three months (spot ~97.0). 

6-12 Month Outlook - Steady appreciation 

Longer-term, we remain USD positive, though the pace of gains should moderate. A direct consequence of the near- 20% rally in DXY since mid-2014 is a significant easing in the stance of policy elsewhere (particularly the Eurozone), beyond the domestic policy easing central banks have delivered. 

As this starts to bear fruit in 2015 H2 and more so into 2016, so USD gains are likely to slow. Our forecasts imply DXY rising to a 12 year high of 102 at the low point for EUR before becoming more of a range trade around 100 in 2016.