Citi FX on the Next Three Years

From ZeroHedge:

Via Citi FX Technicals,
Big picture overview and thoughts regarding the likely backdrop in the coming 2-3 years
Both the 1980-1985 and the 1995-2000 USD rallies were preceded by:

A collapse in housing activity and economic data (1973-1975 and 1989-1991) and stresses in the banking system

A major easing by the Fed (From 13% to 4.75% in 1974-1976 and from 9.75% to 3% in 1989-1992)

Deep recessions

By 1980 and by 1995 the situation had stabilized and bond yields had moved higher in nominal terms and continued to rise in real terms. (By 1983-1984 real yields (10 year yields minus core CPI) were close to 9% and between 1995 and 2000 real yields ranged from around 2 to 5%). This positive “real yield” was undoubtedly a strong factor in the positive performance of the USD during these periods.
For a good portion of the 1980-1985 period (About half) the US struggled with a “stagflationary backdrop” but from 1982-1983 in particular inflation fell sharply making bonds (And a cheap USD) look very attractive.

The 1995-2000 period was pretty much only good news in the US. Strong growth, strong equity markets, an internet/investment boom, a rallying bond market. If it had a “U.S.” tag it was bought.

The important message here is that it does not have to be good news for the USD to sustain its rally, but we are likely to need positive real yields in the medium term. We are getting there. Using core PCE as the inflation reference at 1.2% and a 10 year yield that just hit 3% positive real yields materialized and the USD-index reached a new high at 84.75 in August. However, in the near term, our charts (as seen below) suggest that we may be looking at another dip lower in longer term yields in the weeks/months ahead. This does not necessarily mean that the USD will go down a long way because we should remember that FX and yield differentials are a relative trade. In that respect we would not expect a move to a positive yield dynamic for the Eurozone (Germany) or Japan over the US. However this move lower in yields will likely stabilize sentiment with regard to Emerging markets and the Eurozone in the very near term. At the same time we believe that the Fed will be very cautious about returning to a tapering guidance (as we discussed here "Why the Fed did not taper”)

However from an FX perspective this 1989-1998 period really resonates with us. Why? It was a perfect example of the “interconnectivity of Global markets” and how when the “US catches a cold”, the “rest of the World catches a fever” (From a cross market/cross economy view, we think today resonates more with that period into the late 1970’s)

1989-1991 we had the savings and loan crisis in the US, a sharp downturn in the US economy, aggressive Fed easing and a weak USD. We pretty much replicated that scenario (Only worse) in 2006-2008

1992-1995 this “domino'd” into Europe with the falling apart of the existing “financial architecture” called the ERM (Exchange rate mechanism) which was replaced over the following 5 years or so by an equally flawed structure called the EURO. (Fast forward and we saw the Eurozone debt crisis blow up in 2009-2011). Then the stresses in the World’s 2 major economic zones at the same time as severe economic/financial market/deflation stresses in Japan led us to...

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