Policy divergence to be the clear theme for USD strength in 2015 – BAML

FXStreet (Barcelona) - The Research Team at Bank of America-Merrill Lynch, note that Fed acknowledging inflation concerns due to declining oil prices may temper their USD-positive base case in the near term, but see policy divergence to remain the key catalyst for a strong USD in 2015.

Key Quotes

“Our base case has the Fed largely looking past the big drop in oil prices and breakevens, expecting inflation to rise toward target next year. New York Fed President Bill Dudley articulated that view last week. That said, a few other Fed officials have sounded more concerned about low inflation recently, and the low inflation risks continue to grow, particularly abroad. Thus, a lower-probability but dovish risk to our base case would arise if the FOMC were to acknowledge risks from persistently low inflation, or if Yellen mentions it in her press conference.”

“Right now, the decline in TIPS breakevens may be, in part, a consequence of the Fed not giving them much attention. In our base case, breakevens can decline further and put downward pressure on the long end, with the 5s-30s curve flattening further and perhaps 10y yields declining outright. However, if this meeting were to suggest greater policy emphasis on low inflation going forward, that would support the 2y-5y part of the curve and likely push out of the market implied timing of the first rate hike, resulting in a steeper curve.”

“In FX markets, elevated concern about low inflation could temper the USDpositive signals of our base case in the near term. But, despite the risks at this particular meeting, policy divergence is a clear market theme and the pieces remain in place for a strong USD in 2015.”