1. Developments surrounding the global risk outlook.
As a safe-haven, demand for Dollars diminished from the middle of 2020 as the market’s attention shifted away from the pandemic and towards an expected global synchronized recovery and a reflation environment (both of which is usually Dollar negative). However, global economic data surprises have been on the decline (Citi Economic Surprise Index) and will struggle to surprise to the upside, which means the reflation-induced downside in the Dollar could be running out of steam.
2. The outlook for the FED
A persistent factor for USD has been the Fed's ultra-easy policy stance, downplaying price pressures as mostly transitory, and combined with the AIT framework has largely taken the sting out of upside CPI surprises. Their continued push back against and better-than-expected data reduced normalization expectations. However, the April Fed minutes revealed that some talking about talking about tapering had already occurred, even though Fed Chair Powell expressly said they didn’t. After this, apart from the obvious hawks like Kaplan, other fed officials have also alluded to tapering discussions getting underway with Clarida, Williams, Quarles, and Brainard all showing a slight shift in their commentary and seemingly becoming more open to the idea of beginning tapering discussions at upcoming meetings. Thus, we are arguably further away from NOT tapering, and the closer we get to Jackson hole the more the market's anticipation of tapering will increase.
3. Real Yields
The correlation between US real-yields (10-year) and the DXY has been one of the key short-term drivers for the greenback and given how low real yields have recently trading it could be a struggle for real yields to push meaningfully lower from here, especially if more “peak inflation” narratives come into play as YY base effects see some easing of recent price pressures. Remember, real yields can still go up even if nominal yields move lower, as long as expectations to down faster.
4. Positioning & Liquidity
Recall that the upside seen in the DXY at the start of 2021 was largely driven by the unwind of oversubscribed Dollar short positions, and even though levels aren’t quite where they were in January, the market has once again been happy to accelerate bets on the USD. Liquidity has also been ample for the USD recently as the Treasury’s General Account has been reduced, and once this finite drag is out of the way it should see less pressure on the Dollar. Thus, as we head closer to tapering and with other factors in mind it means the risk to reward to chase the USD lower at cycle lows has diminished and we have adjusted our WEAK bias for the Dollar to NEUTRAL.