The Fed surprise last week caused growing uncertainty among FX investors and removed one potential catalyst for Dollar strength that the FX consensus had been looking for, says Goldman Sachs.
"We now expect tapering to start in December with $10bn. More importantly from an FX point of view, however, is the strengthened forward guidance. Forward 3-month rates on a 2-3 year horizon fell almost twice as much in the US as in many other major markets. The closing gap in the forward interest rate differential has been a clear negative for the Dollar," GS adds.
Moreover, GS continues to believe that front-end rates remain more important for the USD and for FX in general than swings in long-dated yields.
"The FX impact of the latter is quite ambiguous, in particular when foreigners sit on large bond portfolios and rising yields lead to losses and capital outflow, as we have seen in recent months in the US. Shorter maturities, on the other hand, mainly affect carry and hedging considerations. The larger the interest rate differential, the more expensive it becomes to hedge exposure in the higher yielding country. As the cost of hedging rises with rising interest rates, the unwinding of these hedges leads to the appreciation of the higher yielding currency," GS clarifies.
"However, none of these dynamics should apply any time soon in the US, given the Fed’s strengthened forward guidance. Of course, this assumes that inflation does not go up meaningfully and unemployment remains high -- as we and the Fed currently forecast. Even with tapering in some form, it is therefore difficult to see how the Dollar can get a boost from monetary policy currently," GS argues.
In line with this view, GS expects the USD to trade at 1.38 vs the EUR, and 1.68 vs the GBP by year-end.
Read More: http://www.efxnews.com/story/20933/betting-weaker-dollar-goldman-sachs
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