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Its important to note that the model does not take any
aggressive stock market declines into consideration.
Why the Swap Spread is expected to keep narrowing
There is no doubt that the US economy is doing well
right now. Figure 3 shows the PMI composite for the
major markets and showing the US being on top. US
PMI at current levels usually translates into a GDP
growth of 3% yoy. At the same time EU PMI has declined to 52 and the latest Eurozone industrial production numbers to show a decline of -1.9% yoy. This supports the longer term view that the US Dollar may gain
as US economic growth outperforms the rest of the
world.
Yet this idea seems to be well priced in. Figure 4 shows
the US Economic Surprise index showing that US data
has been outperforming and may now turn softer going
forward. This should keep US rates in check and support
a narrowing of the DXY Swap spread, hence a short
term weaker US Dollar.
Summary
The US dollar index may correct to 84/83 before investors may decide to add to long positions.
The reason for the correction would be the DXY moving ahead of rate differentials and the subsequent narrowing of the US 2 year swap rate vs. its major peers in the DXY index.
The trigger for a narrowing of the swap spread was the Federal Reserves concerns about a strong
US dollar and its effect on inflation and on US export orders.
The narrowing of the spread might continue as the near term expectations about the US economy
are slightly elevated according to the US economic surprise index.
Our short term estimate of the US dollar index does not take the risk aversion into consideration,
something that might trigger Dollar buying on safe haven flows.
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