Sitting At The Bottom Of The USD Smile - Morgan Stanley

Our dollar framework has centered around trading the “USD Smile”. Currently, we are sitting at the bottom of the smile – and it’s not until either the US economy outperforms, or the rest of the world begins to slow down – that the USD can find a firmer footing. Recent data suggest that we will stay at the bottom of the smile for a few more months, suggesting that the USD still has some further downside.

On the US side, the economy has come out of the gates at a slow start this year, with Q1 GDP only printing 0.5% SAAR. Retail sales, durable goods orders, as well as consumer confidence have all recently missed expectations as well. Meanwhile, despite a whopping 75% rally in oil prices from its trough in February, survey-based measures of medium term inflation expectations have continued to fall (Exhibit 1). Thus its unsurprising that the Fed remained neutral at its meeting yesterday, not trying to push back against very low market pricing for a hike come June. In order for the Fed to come back into play, economic data need to improve; and inflation, both realized and survey-based, needs to show a steady upward trajectory.

That said, in our view, things are likely only to get worse for now, with our economists expecting YoY core PCE to fall tomorrow from 1.7% to 1.5%/1.6% (U.S. Economics: GDP, April 28, 2016). Thus, though the labor market remains firm, other parts of the economy have not been convincing enough for the Fed to move off the sidelines. It will take a few months of solid data to do so, we think.

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