investment insights
Fine-tuning our bearish dollar forecasts
Key takeaways
- Dollar depreciation has surpassed even our (bearish) expectations. This is a full-blown and fundamentally justified USD depreciation cycle that has further to run, though the pace may slow over the next few months
- We take stock of recent developments and fine-tune our G10 FX forecasts: EURUSD now looks destined to rise above 1.20 and GBPUSD (assuming a basic EU/UK deal) to be supported further
- We also see USDJPY falling to 100, with risks to the downside.
Dollar depreciation has surpassed even our (USD bearish) expectations. Since the recent cyclical peak of late March 2020, the TW USD index has declined by around 10%. The following four factors explain this immense pressure on the greenback:
- Fed pledging to keep rates near zero, which together with the rise in inflation expectations, has led to a massive contraction in US real rates;
- Expectations of a rebound in global economic activity and trade as economies emerge from the unprecedented lockdowns due to the pandemic;
- A significant shift in euro area politics towards fiscal cooperation and solidarity; and
- A worsening of the US pandemic situation which has also coincided with a notable increase in the odds of Joe Biden the November elections (see our recent FX monthly for our take of what a Biden victory would mean for the USD).
All this has resulted in one of the most dramatic G10 FX rallies against the dollar: cyclically sensitive FX has outperformed while traditional reserve currencies have appreciated in line with the dollar decline. We expect further USD downside as the dollar remains overvalued by around 8% based on our estimates.
That said, it is likely that the pace of USD losses will decelerate somewhat over the next few months given the recent sizeable move. We take this opportunity to update and fine-tune a number of our forecasts.
EURUSD- The “anti-dollar” steps up to the plate
We revise our EURUSD forecast to 1.21 by year-end (1.17 previously) and to 1.23 by Q2-21. EURUSD has rallied in line with USD downside, although recent rapid gains can be also explained by positive European political developments. The historic shift in EU fiscal management in times of crisis has significantly reduced redenomination risks and will continue to support the euro. Moreover, EURUSD speculative longs have risen considerably, but are still far from their previous stretched levels that led to currency reversals (see chart I). At the same time, valuation is unlikely to keep providing a tailwind, as EURUSD is fairly close to its equilibrium value (fair value estimates typically range between 1.18 and 1.25). From a portfolio allocation perspective, we think that as EURUSD rises above the 1.20 level, the risk-reward of staying long euros becomes progressively less attractive. In our portfolios, we have been overweight EURUSD for some time now and we consider levels just over 1.20 as appropriate to take profit.
Main risks to our view: We see risks as evenly balanced. On the one hand, EURUSD has frequently overshot fair valuation (see chart II), so it is not out of the question to see a repeat of this, especially at a time when US politics are messy and the European political picture has improved. On the other hand, a significant worsening of the pandemic (or any other black swan event that disturbs global trade) would negatively affect the currency outlook of open economies.
GBPUSD: Pulled higher by USD downside
We revise our GBPUSD forecast to 1.33 by year-end (1.28 previously) and to 1.37 by Q2-21. We would stress that this assumes the UK reaches a deal before exiting the transition period.
Our basic premise on sterling has been that the weaker fundamentals and rising “no deal” Brexit risk premia would lead to underperformance, before a Q4 recovery, assuming a basic EU/UK deal that prevents a default to WTO rules. However, with the broad USD seeing a sharp re-rating lower and reserve type currencies including EUR, JPY and CHF benefitting, GBPUSD has been pulled higher, and now trades above 1.31. Markets have found it difficult to accurately price binary event risks related to Brexit over June-July, though EURGBP is stabilizing at the upper end of a 0.88 – 0.91 range.
We calibrate our forecasts to assume that EURGBP remains well bid until Q3-end. In this scenario, GBPUSD stabilizes at these levels as USD downside and concerns over a “no-deal” Brexit roughly offset each other. By Q4, we think we will be close to a basic UK/EU deal. That could put some downside pressure on EURGBP and support GBPUSD further.
Main risks to our view: EU/UK negotiations fail to find common ground and the UK exits the transition period with no deal. This should see EURGBP rising towards parity.
Japanese yen: Bullish forecast validated
After being quite trendless from April to mid-July, USDJPY has finally broken below the 106 -108 range, coinciding with a sharp decline in US real yields, yet still coexisting with relatively well supported risk assets. We tweak our USDJPY forecasts down to 101 for Q4-20 (103 previously) and to 100 by Q2-21. In an environment of broader USD downside, we believe that USDJPY will decline in both relatively well-supported risk backdrops (in line with previous USD-depreciation cycles – see chart III) while at the same time working well as a portfolio hedge in case risk aversion flares up. Two drivers for this are strong USDJPY overvaluation (our fair value stands at 94) as well as the lower cost for Japanese investors to hedge their US treasury holdings that will see sales of USDJPY increase going forward.
Important information
This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.
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