UBS: Border adjustments and the dollar

EUR/USD has space to rise as market expectations for US reflation remain rich

Being bullish the euro has probably been our most controversial view since November. Despite a hawkish December FOMC, EUR/USD has risen substantially since the start of the year. With hopes for US reflation still in the price to a substantial extent, we may need tangible policy action for the dollar to rally further. We expect EUR/USD to rise over time as the Eurozone recovery firms up further and political risks gradually subside.

Border adjustments and other myths of dollar strength…

In a market fixated with bullish dollar arguments, the prospect of "border adjustments" to US taxation has been widely discussed as the trigger for a possible 20% dollar rally. Yet, the notion that the introduction of a tariff and subsidy scheme (essentially) may lead to a dollar surge is largely academic. We adjust relevant models, and our results point to at most 4-5% broad dollar gain – not 20%. Given recent dollar moves vs. key US trading partners, the market may already be pricing these policy shifts.

…falter against real life cross-checks

And even this moderate dollar strength may not be granted: 1) The USD is not starting from equilibrium but may be overvalued. 2) The US is not a small open economy; instead its actions matter for global prices. 3) Even so, shifts in financial conditions matter much more than short-term CPI shifts for Fed policy, which is the most significant dollar driver. Any tightening in financial conditions and risk sentiment from US policy shifts could lead the USD weaker – not stronger. Overall, it is far from clear that border adjustments will lead to material dollar strength – especially vs. key DMs. This may be more of an issue for neighbouring US trade partners and Asian currencies.

Falling inflation and dovish policy to weigh on CAD

Since the last FX Atlas, the dovish Bank of Canada meeting and the downtrend in inflation have supported our bearish CAD view. Moreover, the near-term costs of potential US policy shifts might balance out the benefits for Canadian growth. We continue to recommend short CAD positions among our 2017 Top Macro Trades.

Take advantage of improving growth with AUD, NZD

In our Top Trades publication, we recommended pairing trades that should benefit from the acceleration in growth, along with assets that should perform well if the pickup in global core inflation remains modest. In FX, this led us to recommend currencies such as AUD, NZD, and CLP, which may have been held back by the rise in US yields. We continue to see support for these currencies from better growth and higher commodity prices, against a backdrop of still-low global yields and inflation.

Stay bearish GBP although the adjustment may take longer

The pound has depreciated much slower than our forecasts imply but we remain bearish sterling. The current account adjustment is still likely to occur while the recent spike in activity is likely to be temporary, inviting easier policy by the BoE. Overall, we think risks are skewed towards markets pricing in more unfavourable outcomes than is currently the case. Yet for sterling to move sustainably towards parity to the EUR markets may require evidence of Brexit- and Current-Account- related growth damage. This may happen by the second half of the year.

Modest NOK bears and SEK bulls as inflation inflects

We turned bearish the NOK last month amid increased downside risks for Norwegian inflation. We also shifted to neutral on SEK, tempering one of our highest conviction calls of 2016. We now expect modest SEK appreciation as inflation lifts. We revise our end-2017 EUR/SEK forecast to 9.4 from 9.8.

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