US Dollar Set for "Corrective but Tradeable Rally" say Morgan Stanley

-US Dollar to rise against risk currencies as tensions escalate.

-Australian Dollar, Canadian Dollar, Pound likely FX losers. 

-US economy to hold steady but stocks set to take a dent.

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The US Dollar could be set to rally against "risk" currencies in the coming weeks, according to Morgan Stanley, as markets respond to a decline in global risk appetite and a rise in short term market interest rates.

Strategists at the bank are watching the latest developments on the international trade front keenly, as well as events in interest rate markets, and have flagged both the Australian Dollar, Pound Sterling and New Zealand Dollar as among those likely to suffer the most in the current environment.

"The USD is set for a corrective but tradable rally, aided by diverging global growth and waning risk appetite," says Hans Redeker, head of FX strategy at Morgan Stanley. "Economic growth differentials favoring the US economy, coupled with global growth weakening, creates a perfect environment for a USD rally."

The call comes after President Donald Trump signed an order requiring around $60 billion of tariffs on goods imports from China, citing section 301 of the Trade Act 1974, which has already drawn threats of retaliatory action from the Chinese. China has already retaliated against aluminium and metal tariffs announced by the White House earlier in March. 

"Should trade issues escalate from here, the US economy may initially suffer less than its trading partners. Expansionary fiscal policy should help to protect demand at least initially, and a gain in the trade balance is a net positive for GDP growth,all else equal," Redeker adds.

This escalation of earlier tensions has heightened fears of a trade war between the world's two largest economies, which hit global stock markets overnight and on Friday morning. US stocks fell modestly while Japan's NIKKEI index dropped -4.5% and China's Shanghai Composite slid -3.5%. In Europe, the German DAX was down -1.5% while the French CAC 40 was -1.4% lower. The FTSE 100 in London shed -0.57% Friday.

Separately, the US Dollar shifted its stance repeatedly in the session after the White House tariffs were announced, initially winning ground from its international rivals overnight only to retreat during morning trading in London. The US Dollar index was 0.15% lower at 89.68 just before noon Friday.

"Equity markets may enter April on the back foot, with tariffs and their potential impact on global growth, inflation, and profit margins undermining investor confidence...portfolio managers will have to adjust their values at risk reflecting increasing uncertainties, suggesting reduced equity market demand," Redeker notes. "The USD has been negatively correlated to share prices."

The Morgan Stanley team also forecast the US Dollar will see additional support against a select basket of other currencies over coming weeks due to events in the interest rate market, which have seen the so called LIBOR-OIS spread widen to levels not seen since the financial crisis. This is the difference between the cost of borrowing US Dollars at the London Interbank Offered Rate (LIBOR) and the rate charged to exchange liabilities in the US Dollar overnight index swaps market, which closely tracks the Federal Reserve’s main interest rate.

"The US LIBOR-OIS spread wideninghas spilled over into other USD-pegged environments such as the GCC countries and Hong Kong. Canadian banks derive 29% of their financing from wholesale funding, while for Australian banks this is 34%," Redeker writes Friday.

The US LIBOR-OIS “spread” has doubled from around 25 basis points to more than 50 basis points (0.5%) so far in 2018. The cause of the move has been a rise in the LIBOR rate which, being the rate banks charge each other to borrow over short periods, has raised financing costs for all who deal in US Dollars.

"AUD LIBOR-OIS spreads widening works in favor of our short AUD positions as the wider spread represents a form of monetary tightening,absent changes in RBA policy," Redeker notes, flagging one of the most likely victims of a Dollar rebound in the coming weeks.

Morgan Stanley attributes the increase in LIBOR to an increase in the number of short term bonds issued by the US treasury, a rise in demand for short term financing in US Dollars and President Donald Trump’s tax reforms, which appear to be acting like a vacuum cleaner that is hoovering US Dollars from the international financial system as companies repatriate foreign profits previously invested in Dollar denominated money market instruments.

"Cyclical currencies will stay offered...It is clear that the evolution of volatility will be critical," Redeker writes, before flagging that China's response to the White House trade measures will be critical to markets in general as well as the US Dollar LIBOR-OIS spread in coming weeks.

The Pound-to-Dollar rate was 0.10% lower at 1.4097 while the Euro-to-Dollar rate was 0.01% higher at 1.2325 at noon Friday. The USD/JPY exchange rate was 0.01% higher at 104.97.

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