USD: Perfect Storm Ahead For USD liquidity; Staying Tactically Short EUR/USD – Danske

Danske Bank FX Strategy Research warns of the risk that a perfect storm may hit USD liquidity in H2 17.

“Besides Fed rate hikes and quantitative tightening the US Treasury will likely soon begin to drain liquidity from the market, when a solution to the debt limit issue is found. US Treasury exhausts its ‘extraordinary measure’ possibly early autumn so Congress must either lift or suspend the debt limit soon to avoid a US government default. 

As we expect a deal to be reached eventually (although most likely not until very close to the deadline whenever it precisely is), the US Treasury will likely begin to rebuild its cash buffer (which US Treasury aims at USD150-450bn) in late Q3 or in the beginning of Q4 this year, thus draining dollars from the system.

As the Fed may be too optimistic about its ability to shrink its balance sheets, we see a risk of the start of an unwarranted tightening of USD liquidity over the coming 3-12M depending on the timing of the start of the reduction. That should widen the EUR/USD XCCY basis and be a negative contributing factor for EUR/USD, especially now that 40% of the reduction is conducted by ceasing reinvesting mortgage backed securities,” Danske argues.

In line with this view, Danske stays tactically short EUR/USD* in its Portfolio for a dip below 1.10 in the cross over the summer driven by a Fed determined to move on with policy normalisation and an ECB that could be side-lined for a while as inflation and eurozone growth lose momentum.

Source: Danske Bank Research

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