M Global IdeaG10 FX StrategyMoving to Neutral on the USDMorgan Stanley & Co. International plc+David S. Adams, CFAStrategist David.S.Adams@morganstanley.com +44 20 7425-3518 Wanting LowStrategist Wanting.Low@morganstanley.com +44 20 7425-6841 Morgan Stanley & Co. LLCAndrew M WatrousStrategist Andrew.Watrous@morganstanley.com +1 212 761-5287 Zoe K StraussStrategist Zoe.Strauss@morganstanley.com +1 212 761-0407 Morgan Stanley & Co. International plc+Dominic J KrummenacherStrategist Dominic.Krummenacher@morganstanley.com +44 20 7425-9781 The USD tried - and failed - to rally as falling rates and buoyant risk appetite drove Regime 1 in FX, generating universal USD weakness. We turn neutral (from bullish) on the USD but still see tactical upside risks given positioning, seasonality, and overextended momentum. Pivot short EUR/USD to short EUR/JPY.Homer Simpson was right: "Trying is the first step toward failure," said Homer. The USD tried to rally in early December but this proved short-lived. US data deceleration, coupled with the market interpreting a dovish pivot from the Fed, fueled a decline in US rates, in turn bolstering risk appetite. Falling real rates and higher equities is Regime 1 of our USD framework, which sees universal USD weakness.USD strength is harder to envision: In our year-ahead outlook we said USD strength would continue, driven by growth outperformance, favorable rate differentials, and investor defensiveness. US data deceleration has compressed growth differentials, US rates have fallen further compared with peers, and investors appear far from defensive based on equity returns.Turning neutral on the USD... We turn neutral on the USD as our conviction about USD strength has waned meaningfully. Investors appear to be adopting an 'early cycle' mentality where peak Fed hawkishness is sufficient to 'paper over' other risks. It's not so clear if previous USD-positive catalysts, such as upside surprises to US growth, downside surprises abroad, or an optical uptick in core PCE moving averages will be enough to weigh on risk and bolster the USD....but risks remain skewed toward USD strength: That said, we note three important (tactical) USD-positive risks. First, positioning has turned meaningfully USD-negative. Second, seasonality has turned from USD-negative in December to positive in the first quarter. Finally, the USD's selloff has overshot what historical relationships imply.Pivot short EUR/USD to short EUR/JPY: The cloudier outlook for the USD doesn't change the fundamentals for the other G3 currencies, in our view. JPY should continue to gain as long as US rates are falling, regardless of the risk outlook. Meanwhile continued downside surprises in Eurozone data, particularly inflation, could lead EUR to re-emerge as a funding currency of choice given its lower carry versus the USD and risks from a dovish ECB pivot down the line.Please ...
