BofA: Fed Will Hike

ZH: Bank Of America Reveals "The Next Big Trade"

In recent years, FX investors had to focus primarily on getting three key market drivers right: global risk sentiment, commodity prices, and which central bank will ease more and deeper into unconventional policy territory. Interaction between these three made life difficult for FX investors. However, looking back, these three can explain the biggest moves in the FX markets in the post-crisis years: the JPY weakening when Abe and Kuroda pushed with Abenomics; the EUR weakening when the ECB introduced QE after a long delay; the weakening of commodity currencies when oil prices collapsed; the strong CHF during the Eurozone crisis and when the SNB removed the EUR floor; and the EM rally during Fed QE and the sell-off when the Fed started QE tapering, to mention some of the most notable examples.

However, something fundamental has changed in the FX markets this year. Risk sentiment and commodity prices remain key market drivers, with China and oil prices in particular. But the market reaction to central bank policies has changed substantially.

Five G10 central banks have surprised markets with their policy easing this year, namely BoJ, ECB, RBNZ, Riksbank and Norges Bank, but their currencies are now stronger. With the exception of New Zealand, equities are also down for the year in these countries, which raises questions about the effectiveness of their monetary policies. In relative terms, the RBNZ was the most effective in weakening its currency, while the Norges Bank the least effective. A weaker currency may not be the main goal of monetary policy easing, but a stronger currency--and weaker equities--after having eased more than markets had expected is definitely a puzzle.

We have recently argued that markets have stopped focusing on what central banks are doing and are now focusing on what central banks may or may not do ahead.

If the BoJ or ECB suddenly called off their intervention, initially there's the shock reaction and likely rally in yen or euros, but then comes the reckoning. Does the currency rise or fall? Long-term interest rates? These questions don't need answers though, because it's theoretical. BofA thinks the Fed is among the most likely to tighten:

This suggests that inflation pressures and overheating are more likely to force the hands of the Norges Bank, Riksbank and the Fed to stop easing/tighten, while the ECB, the BoJ and the SNB are likely to retain a loose monetary stance and even ease policies more.

And the dollar bull market will resume with a vengeance.