Sara Yates, JP Morgan private bank’s vice president global FX strategist says the US is outperforming

The US economy is outperforming and it is likely that it will be the first to exit from unconventional monetary policy.

This means there is upside for US longer dated yields, which will support the USD. But this is not news. In our FX quarterly “the two sides of USD
diversification” focused on how to position in an environment where the USD is likely to be relatively strong. In a nutshell it has two

• First, a currency other than the USD needs to be used as the funding currency. Our favourites are the JPY and CHF.

Just to highlight why this is important, let’s imagine a USD based client bought an EM fund this year which has returned a 3% return. If the purchase was funded from USD the total return would be 3%. Whereas, if it was funded from JPY (or overlaid with a long USDJPY position), it would have returned 17%. If the transaction had been funded from CHF, the return would have been 8%.

We continue to believe that the diversification of liabilities will be as, if not more, important in delivering returns as the
diversification of assets this year.

• Second, when the USD is doing well, it is very hard for EM FX to outperform. Consequently, we believe the largest component of EM FX returns will come from carry not spot appreciation.

Although the US’s economic strength is known, what isn’t known is when the exit from unconventional policy will start and how it will be done. So far, FOMC members’ opinions have varied considerably.

Of all the FOMC members, Bernanke’s comments matter most. As a result, his response during the Q&A session of his Congressional appearance that they could “take a step down in the pace of purchases” reduced the market’s uncertainty over when tapering will begin, supporting US yields and the USD.

What Bernanke’s comments did not do was to quantify the potential change to the quantitative easing programme. We expect the Fed to be cautious in its exit strategy, but there is a risk that it moves too quickly and cause risky assets (and currencies) to come under pressure.

We believe the potentially more aggressive time table suggested by Bernanke increased market concerns about this risk and that is why the USD’s strength was particularly visible against EM and commodity currencies.

In our view, some of last week’s USD strength was premature. As we noted in this week’s weekly, the contraction in US industrial production in April, alongside weak readings from the Phili Fed and Empire State Manu surveys suggest there is still room for improvement in the US economy.

We also think the market’s substantial focus on Bernanke’s Q&A response has been to the detriment of it overlooking his actual testimony where he made clear he believes the “job market remains weak” and that “consumer price inflation has been low”.

Given that he also said that the pace of purchases would depend on the “outlook for the labour market or inflation changes”, we think the tapering is still some way off. This suggests the possibility of some unwind from this week’s USD moves.

Nonetheless as the year progresses, we expect US yields and the USD to remain supported. This will be a challenging environment for EM
FX and one where selection will be key.

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