ANZ says political risks have shifted from Europe to the US and that's weighing on the greenback

US President Donald Trump (L) shakes hands with French President Emmanuel Macron ahead of a working lunch, at the US ambassador’s residence, on the sidelines of the NATO (North Atlantic Treaty Organization) summit, in Brussels, on May 25, 2017. Photo: AFP PHOTO/Peter Dejong/Getty Images

The US dollar has been on the back foot recently, completely unwinding the rally seen in the wake of US president Donald Trump’s election victory in early November last year.

It’s been a noticeable shift, disconnecting from yield differentials to other major currencies which helped to propel it to a more than decade high in the early parts of this year.

In May alone the US dollar index (DXY) has lost 1.4%, something that hasn’t been seen at this time of year for seven consecutive years.

That divergence is seen in the chart below from ANZ, overlaying the DXY against 2-year yield differentials to other currencies in the dollar basket.

Source: ANZ

According to ANZ’s FX strategy team, the reason for the disconnection between yield differentials and the DXY has been a shift in political risk, moving from Europe to the US, placing downward pressure on the dollar as a consequence.

“Not only have expectations of US fiscal stimulus been priced out, but a political risk premium is now being priced into the USD following recent US political developments,” says ANZ.

“As a result, there has been a growing divergence between the DXY and yield differentials between the US and interest rates of the economies within the DXY index.”

Not only are traders questioning whether Trump can show his deal-making prowess in terms of taxation and healthcare reforms, there’s also increased nervousness as to whether recent scandals will see him exit before a full term in office.

And, as those concerns have grown, ANZ notes that political risks in Europe have ebbed, helping to support the euro, the largest component within the US dollar index.

“Part of the USD yield divergence story also reflects the removal of the political risk premium from the EUR,” the bank says.

“The election of Emmanuel Macron in the French Presidential election and the success of the Christian Democratic Union (CDU) in recent state elections in Germany have greatly reduced concerns of a rising populist tide in Europe.

“As a result, markets have started to put their focus back on the economic fundamentals in the euro area, which have been showing signs of improvement.”

Given that perceived shift in political risk from Europe to the US, ANZ has decided to lift its forecasts for not only the Euro against the dollar, but also for the British pound and emerging market currencies across Asia.

“We have lifted our EUR and GBP forecasts to factor in the weaker starting point for the USD and reduced political uncertainty over the euro area. We have similarly revised our USD/Asia forecasts to factor in the current negative sentiment towards the USD,” it says.

Here’s ANZ’s updated forecasts.

Source: ANZ

ANZ still sees the US dollar strengthening modestly once political uncertainty is removed from market pricing, suggesting that the dollar will find support given the Fed’s monetary policy tightening cycle is well ahead of those in Europe and emerging markets in Asia.

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