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What’s behind the divergence between USD & nominal rate differentials? – Goldman Sachs

Goldman Sachs Economic Research explains the reason for the drop in the US dollar despite relatively stable nominal rate differentials.

Key quotes

Front-end market pricing for Fed hikes is roughly unchanged since the start of 2017, with about 125 bps priced through end-2019

Most hypotheses, like better global growth or a US inflation overshoot, don’t explain why nominal and real rate differentials are so stable, even as the currency has fallen

We believe the principal reason for the divergence is “Dollar down” rhetoric from the new administration, which we think highlights the constraints facing President Trump, rather than likely outcomes. After all, a policy mix that combines fiscal stimulus and protectionism is hard to reconcile with a weaker currency, even if that is what the new administration wants.

The last episode when USD diverged meaningfully below rate differentials began a year ago, when market fears over a large RMB devaluation were building. That episode lasted over six months, ending with the Nov. 8 election. The current episode should be shorter, with a good run for US data – our expectation – the tie breaker.

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