US: Can the USD sustain the reflationary trade? - Rabobank

Jane Foley, Senior FX Strategist at Rabobank, suggests that on the back of the US Presidential election the USD has sustained a winning streak vs. the EUR which has been driven by a sharp re-pricing of US inflationary risks and an aggressive widening in the spreads between yields on US Treasuries and Bunds. 

Key Quotes

“Given the strength of the market’s conviction that the Fed will be tightening policy in December, it would seem reasonable to expect that bond yields can hold their firmer tone in the near-term.  That said it is difficult to see continued support for the reflationary trade and this suggests risk that the USD could give back some of its broad-based gains next year.  Not all currencies have responded equally to the reflationary and protectionist policy changes that have been outlined by the President-elect.”   

“The strength of some of this week’s US data releases played nicely into the reflationary mood that has been gripping US markets in the wake of last week’s Presidential election.  Housing starts dramatically registered a 9 year high and initial claims recorded the lowest number since 1973.  The latter provides more evidence that the US labour market has reached a very tight level.  That said, Fed Chair Yellen sounded a note of caution by remarking that “there nonetheless appears to be scope for some further improvement in the labour market”.  This comment is likely derived from the fact that wage inflation remains subdued suggesting that there may be less inflation risk in the economy than the market is currently assuming.”

“Where is the wage inflation? 

In recent years it has become obvious that there have been structural factors bearing down on inflation.  A significant culprit is the softness in wage inflation.  This is a phenomena that is evident in the US, Europe, Japan and Australia.  In Q3, Australian wage inflation recorded a record low 1.9% y/y.  In general low wage increases can be linked to low rises in labour productivity and to the trend for more capital intensive businesses which is reducing the share of income that is being distributed to workers.  Yellen this week referred to this in her Congressional testimony.  The move towards more capital intensive business has contributed to stagnant household incomes and to rising income inequality as the owners of the capital take a greater share of the spoils.”

“We would argue that these trends are heavily related to the rise in anti-establishment and anti-globalisation sentiments that are obvious in the electorates across the US, European and Australia.  We would also point out that these structural issues have not altered over the past week and that there is significant risk that the policies being muted by Trump will not address these issues.  Although the President–elect has promised to return well paid jobs to the heartlands of America, this would likely have the effect of raising the prices of products on the shelves of US stores and reduce the real incomes of households.  In short, there is good reason to fear that demand led inflation could remain muted and that some of the reflationary hopes that have been pinned on the President-elect have been overdone.”