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With US-centric drivers fading from prominence, idiosyncratic and global drivers emanating from other regions will play a greater role in driving FX going forward. Many of these drivers have come from Europe recently, including the pricing in (and subsequent de-pricing) populism risk around European elections over the past several weeks. Added to this have been the ongoing run of positive Eurozone data surprises, and relatedly, the constructive/hawkish shift in ECB rhetoric recently.
The other major global driver to note is reflationary forces, as indicated by the longest run of upside activity data surprises since 2009 (see above chart), driving a continued grind higher in carry and high-beta FX. Two weeks ago we had warned that carry would be vulnerable to a hawkish Fed reaction function shift. Today, the opposite is true, where a Fed out of the headlines for possibly a protracted period of time translates to a lower hurdle for carry and high-beta FX to continue to outperform.
The confluence of better data, hawkish ECB speak, together with the declining risk from European populism most recently collectively biasing a directionally stronger and outperforming EUR has pushed average pairwise correlation of EUR crosses above that of USD crosses for the first time in nearly a year(see above chart).
After having avoided the dollar for much of this year, we went tactically long the dollar (via CAD and GBP) two weeks ago on a seeming green light from the Fed.
We now once again want to reduce dollar exposure. There are no foreseeable near-term positive catalysts, but at the same time, the discount versus yield spreads is somewhat extreme (at 2-sigma cheap).
Washington risks remain landmines, but the directionality is ambiguous (potential dollar-bullish surprise breakthrough in tax reform, or potential dollar bearish currency policy?).
We start to rotate away from outright dollar risk by blending our short GBPUSD with a long EUR cross (long EURGBP through options), gaining more exposure to the decline in European populism risk and cyclical upturn.
Meanwhile, we blend our USDCAD long into an AUDCAD cash long to gain exposure to carry, while looking for tactical opportunities to exit our outright USD longs in the coming weeks.
Finally, with less USD centrality, other the other idiosyncratically driven trades should perform more consistently.
