Who’s got the inflation to drive FX?

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According to Goldman the US does:

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1. Since the US election, inflation in the major advanced economies has been repriced to the upside at the front end and long end of inflation curves, which are now relatively flat. Even though inflation break-evens have traded in a tight range since the beginning of the year, we often hear from clients that a reflationary view is well expressed in break-even inflation and nominal rates trades, rather than in FX. Our Rates strategists recently reiterated their positive views on European and US inflation break-evens . On the FX strategy team, we have shown that inflation matters for FX returns and, hence, we disagree with the view that there are no opportunities to express the reflationary theme in FX. Long USD positions versus G10 currencies – and in particular EUR and GBP – offer a prospective positive return that is not priced in the FX forwards and, as our analysis below shows, inflation plays a relevant role in this dynamic.

2. In this FX Views, we use our Real-Time FX Return model (which from now on we will call the GSRFR model), which we presented in the recently published Global Economics Paper: Forecasting G10 FX returns with real-time macro factors, 02 Feb 2017, and show that the inflation outlook matters for FX returns. More specifically, we focus on the USD trade-weighted index (which we construct versus all other G10 currencies), and the EUR/USD, USD/JPY and GBP/USD crosses. We use the coefficients estimated with the GSRFR model and our economists’ forecasts for the macro variables included in the model to predict FX returns up to 24-months. We then compare these predicted returns with the FX returns priced by the FX forwards to highlight opportunities over the near term. Finally, we simulate how prospective FX returns change if we use Consensus Economics forecasts (rather than our forecasts), and we make available an excel spreadsheet (see here) where clients can input their own forecasts for macro variables and see how the potential FX returns change based on our GSRFR model.

3. Exhibit 1 shows our economists’ forecasts for headline inflation over the coming two years for the US, Euro area, Japan and the UK, as well as the weighted average of all G10 countries excluding the US (weights are based on trade shares between the US and all other G10 countries). The US maintains a positive inflation differential versus all G10 countries over the coming 24-months, with the exception of the UK, where inflation accelerates above that of the US in 2018. The GSRFR model predicts 4. Our predicted FX returns for the USD TWI and USD/JPY are more bullish than the forwards (Exhibits 3-4) and our predicted FX returns for GBP/USD and EUR/GBP are more bearish (Exhibit 5-6). A similar picture emerges when we simulate future FX returns using Consensus Economics forecasts for the macro variables included in our GSRFR model. On the contrary, over the next 12- to 24-months, the market is pricing a slight appreciation of the USD versus G10 currencies. As we argued in FX Views: This is NOT the End of the Dollar Bull Run, 02 Feb 2017, the market is not pricing the difference in economic conditions and inflation outlooks among major DM economies, and instead is focusing on the ‘Dollar down’ rhetoric of the new US administration or on the pick-up in inflation in other countries. Our view remains that the Fed will set its monetary policy independently, based on the data, and that the market will learn to give less importance to the administration’s comments on the USD than to the economic outlook and to appreciate that the US maintains a positive inflation differential versus all other G10 countries over the coming 24-months, with the exception of the UK.

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A solid base case given the slowly tightening labour market, confidence lift, shale rebound and fiscal outlook.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.