1-3 Month Outlook of US Dollar – 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 remains priced for a later start to the US tightening cycle. Forward Fed funds are only a full 25bp above recent realised rates in January 2016 - four months later than the September 2015 hike, expects RBC Capital Markets. 

If the monthly indicators continue to come in consistent with a 3%+ annualised increase in Q2 GDP, a repricing of US rates to drive another significant leg higher in USD, says RBC  Capital Markets. Indeed, with rate expectations outside the US unlikely to fall much further from here (in fact RBC's  Capital Markets 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. 

The 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 long-USD 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).