US elections resulted in dollar reset – Goldman Sachs

Research Team at Goldman Sachs, suggests that the USD strength in recent days can extend and see the US election as something of a “reset.”

Key Quotes

“As early signs of a Trump victory made their way into the markets during the night from Nov. 8 - 9, the Dollar fell in line with this pattern, but reversed sharply as President-elect Trump began giving his acceptance speech, which projected a conciliatory and inclusive message. This set off a rally in risk, which has morphed into markets trading a positive growth shock to the US: Dollar up, inflation breakevens up and SPX up.”

“Amid substantial uncertainty, our US team has kept is growth forecast unchanged. There is upside risk from the fiscal stimulus, while there is downside risk from an escalation in protectionism.”

“But in either case, inflation is likely to be higher than before, which is what has probably helped drive inflation breakevens up. As a result, market pricing for Fed hikes has risen sharply, with tightening priced through Sep. 2019 now 86 bps, almost a full hike more than at points before the election. Our point here is not that risks don’t exist. Of course they do. Instead, it is that the policy mix has shifted in the direction of more inflation, which means that – given how dovish market pricing has been – there is room for the Dollar to catch up with where it should have been quite some time ago. Our US team forecasts three hikes next year in addition to the one now likely in December. This is more than double what is priced and underpins our forecast for the Dollar to rise around 7 percent on a trade-weighted basis over that horizon.”

“There are three additional issues of note. First, the Dollar is driven by two-year rate differentials, so the December meeting is clearly important. Our US team has emphasized financial conditions, which are moving in favor of a hike. Second, the inflation story is really something unique to the US, but if we look at trade-weighted inflation breakevens, US inflation has yet to break meaningfully above that elsewhere.”

“The inflation picture in Europe and Japan is difficult, so the market is not yet pricing this correctly. This translates in our minds into more Dollar upside. Finally, there is China. The prospect of more Dollar strength may obviously see the $/CNY fix move higher. But our best guess is that moves will be at the modest end of the spectrum, given that failure to do so could antagonize the incoming US administration. It might be time for the CFETS basket to go up a little bit, which would set things off on a good foot in Washington come January.”