Goldman Sachs reviews and updates its core beliefs about the
foreign exchange market this year
In late January, Goldman Sachs analysts published
10 Commandments for the 2016 FX market
. Now they take a second look.
From Goldman Sachs:
Over the past month the market has put the USD under substantial
pressure, and the DXY has fallen almost 4% since the end of
January. The market has all but eliminated Fed rate hikes from the
US curve for the rest of 2016, and the USD is lower versus both the
EUR and the JPY as risk sentiment has suffered. This sell-off has
stopped us out of our 2016 Top Trade recommendation to be long USD
vs EUR and JPY.
In response to this uncertainty, last month we published a list
of core 'truths', which we think will prevail and dictate market
direction this year. We revisit and update these below following
the BoJ's January easing, and even more market turmoil in recent
1. Much more US outperformance than priced.
Behind all the short-term worries lurks one important fact that is
often overlooked. The Dollar has appreciated 26% versus the majors
over the last two years, but US growth has stayed above trend.
There is little doubt that net exports and inflation have suffered,
but the resilience of the economy suggests that underlying momentum
on both the growth and inflation fronts is better than priced,
especially now that front-end interest rates have priced out so
2. The ECB and BoJ can and will ease more.
In the wake of recent disappointments, markets worry that the ECB
and BoJ are reneging on their commitments to boost inflation, which
has been weighing on risk. Both central banks have progressively
cut their 2016 core CPI forecasts, fanning fears that they are
'terming out' their inflation targets. Indeed, our European
Economics team forecasts core HICP at 1.0% this year, below the
1.3% ECB forecast, an illustration of the downside risk to an
already low number. In our view, the January BoJ meeting
demonstrated the BoJ's ongoing commitment to its inflation target,
even as the market has come to doubt the efficacy of its move to
negative rates. For both the ECB and BoJ, we expect more stimulus -
in addition to their recent easing steps - as opposed to reneging,
which is the basis for
our 12-month view of $/JPY at 130 and EUR/$ at
3. G-3 central banks will get over their fear of
Fear of floating among the G-3 central banks has a price, which is
that it destabilises risk, inadvertently tightening financial
conditions. One example is the September FOMC, which exacerbated
market anxiety over China with its focus on financial conditions.
Another is the December ECB, where concern over excessive Euro
weakening was reportedly one driver for not taking more aggressive
action. Both times, equity market declines caused financial
conditions to tighten, making efforts to manage G-3 exchange rates
counterproductive. We expect the G-3 central banks to accept more
Dollar strength as the lesser of two evils.
4. Low inflation for longer in the Euro
Much of the discussion over low inflation in the Euro area revolves
around global themes, including falling commodity prices and the
slowdown in EM. But ongoing structural reforms in periphery
countries mean that price and wage levels are likely to keep
falling, imparting a deflationary bias to the region, which is
distinct from global developments.
5. Negative interest rates are not a QE substitute
. We estimate that a 10bp (surprise) deposit cut is worth two big
figures in EUR/$, based on intra-day moves when surprise deposit
cuts were announced (September 4, 2014 and October 22, 2015). This
means that the bulk of the decline in EUR/$ stems from ECB balance
sheet expansion and long-term interest differentials not front-end
rates. Our forecast for EUR/$ down anticipates a shift in emphasis
back to asset purchases from depo cuts. In the case of Japan,
negative rates have augmented rather than substituted for existing
QQE measures, and the impact has been to push JGB yields much
lower. While the sell-off in risk assets has flattered JPY through
interest rate differentials, we expect that ultimately this fall in
the JGB curve will push JPY lower via portfolio rebalancing, as in
point 6 below.
6. The BoJ is the ultimate QE warrior.
Quantitative easing aims to boost growth via a portfolio shift out
of safe-haven assets into risk assets. The QQE program has
aggressively flattened and stabilised the JGB yield curve,
encouraging that shift, such that $/JPY sees 'autonomous' moves up
when risk appetite is good, for example in the summer of 2014 (the
move from 102 to 109) and May 2015 (the move from 120 to 125).
EUR/$ has not benefited from similar portfolio shifts because Bunds
- the safe-haven asset in the Euro are - have been too volatile.
And, as above, in Japan negative rates have not been introduced as
a substitute for further QE, but as an augmentation.
7. The Dollar is a 'risk-on' safe-haven currency
. The correlation of the Dollar with risk has flipped from negative
to positive in recent years. This switch reflects rate
differentials, rather than a loss of safe-haven status. Negative
growth shocks, real or perceived, cause markets to price out
monetary tightening in the US, such that rate differentials move
against the Dollar. The positive correlation of USD with risk is
therefore really a reflection of US cyclical outperformance.
8. Near-term pain, long-term gain for USD from low
have a negative fall-out on economic activity in the short run,
weighing on the Dollar by way of rate differentials. But the US
remains a net oil importer, so that low for long in oil prices is
fundamentally a Dollar positive, once near-term effects drop out.
By way of illustration, it was the oil super cycle that derailed
the Dollar-positive impulse from rising rate differentials in
9. China's balance of payments is under
There is a lot of anxiety that the pickup in capital outflows
represents a run on the RMB, making a large devaluation all but
inevitable. However, a key reason that outflows were so large in
2015 was that August and December saw the RMB fix weaker, which
caused (heavily expectation-based) outflows to pick up. With a
current account surplus of perhaps as much as US$400bn this year,
China's balance of payments can absorb a sizeable level of outflows
before reserve drawdowns become necessary.
10. It is not in China's interest to destabilise the
. China is a net exporter, i.e., it depends more than other
countries on sound global growth. It is therefore hardly in China's
interest to unsettle markets and derail the world economy. Recent
developments most likely point to a greater desire to see
flexibility in the exchange rate and a closer link to fundamentals
(which includes a shift in focus to a tradeweighted exchange rate),
rather than unilateral devaluation.
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