We discuss the channels through which US inflation outperformance affects the FX market, concluding on a case for continued USD weakness.
Our 'inflation-divergence-corrected' EUR/USD estimate is 1.30 - we still see the cross headed for 1.28 in 12M.
The Fed's reaction to inflation risks is key short term but room for inflation to move higher within FOMC comfort zone should keep rate support to USD subdued.
Norwegian vs Sweden inflation divergence makes long NOK/SEK attractive still.
Clients with USD income/assets should keep high hedge ratios and use longer-dated forwards and/or options for hedging - we stay long EUR/USD via options.
Causes of inflation are several...
While the mounting upside risks to inflation, as discussed in Part 1-3 of this research series, are to some extent a global phenomenon, US inflation risks dominate our 2018 outlook. To assess the USD implications of this, we separate the inflation forces as stemming from:
- A US fiscal boost , deriving both from Trump's tax reform and spending bill.
- A maturing cycle in notably the US, looking to bring Philips-curve dynamics to life.
- Upside risks to global commodity prices as not least oil supply-side risks are present.
While the latter two may affect USD via the shock to actual/expected inflation, the first is key in the current setting and may in itself have USD implications. However, due to counteracting forces, it is not obvious from the outset what the net effect on USD is.
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