It is evident that the market has grown tired of the divergence in monetary policies as a theme driving currencies. The USD has to a significant extent already built in a tightening cycle. The market has paid more attention recently to nuanced shifts away from further policy easing in Europe and some other countries. The USD has fallen despite two rate hikes since December, and reversed most of its ‘Trump bump.’ The market appears in a mood to be looking for a reversion to the mean in exchange rates. However, even though the USD is above its long-run average levels in real effective terms, its overvaluation is not excessive on broad indices. The USD yield advantage has risen to historically high levels, and against many currency pairs, the USD appears cheap relative to yield spreads. The Fed seemed to hike in response to stronger equities, narrower credit spreads and a weaker USD this year (easier financial conditions) rather than on any additional confidence in the outlook for US growth and inflation. The market is aware that the US administration and the Fed appear to prefer a weaker USD and this may be detracting from its performance, even as USD rates rise. At some point, the under-performance in the USD relative to its improved yield advantage should end. Perhaps it will take clearer evidence that inflation pressures in the US are picking up. It remains the case that the Fed’s rate outlook and the USD have built-in little prospect of fiscal stimulus, or a border tax, both which point to upside risk for the USD. The equity market continues to show strength, suggesting it is responding to evidence of stronger growth globally and domestically, and remains confident that tax cuts will be delivered. The USD and rates market appears more pessimistic on the economy and doubts Congress can deliver tax reform, and other growth-boosting policies. We acknowledge that the USD is struggling, but we are still biased to buy USD and will be looking for signs that it is breaking out of its rut. Our look at real effective exchange rates and yield spreads continues to suggest that the NZD is significantly over-valued.
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