EUR/USD, USD/JPY: Divergence Is Diverging: New Targets

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FX strategy at GS has traditionally been Dollar bearish. The rationale was that the dual mandate of the Fed makes it structurally more dovish than the ECB or BoJ, while underlying current account positions are a drag on the Dollar and a boost for the Euro and the Yen. We broke with tradition in April 2014 when we became Dollar bulls, forecasting that the coming normalization of US monetary policy would lift the Dollar around 15 percent versus the majors.

Through January the Dollar had risen by 25 percent, but a combination of China devaluation fears, a more dovish Fed and mistakes by the ECB and BoJ took a toll and the greenback is now only 17 percent above its April 2014 level (Exhibit 1). Conviction levels that the Dollar can resume its rise are low, with one gage the CFTC’s Commitment of Trader’s report, where speculative Dollar shorts are the largest since 2013 (Exhibit 2).

This FX Views updates our Dollar outlook. Given how dovish the market is on the Fed – interest rate futures price 40 bps in tightening through 2017 – we still see the big picture as Dollar supportive, even with the slower pace of hikes our economists now forecast. But the ECB and BoJ are tricky. Above all, monetary policy at the zero lower bound is an expectations game, where central banks need to surprise again and again to convince markets of their determination to raise inflation. The ECB has now disappointed markets twice, while the BoJ made a tactical error with its shift to negative rates.

Ultimately, we believe that the BoJ will continue to surprise and retain an aggressive forecast for $/JPY higher, even near term. However, we delay some of our expectation for EUR/$ downside well into next year, given mixed messages from the ECB.

Overall, our view remains that the Dollar will rise a further 13 percent, but that appreciation is tilted against the Yen near term and more back-loaded elsewhere. Divergence is diverging.

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