investment insights
Tentative dollar divergence, continued euro weakness
Key takeaways:
- Two months ago, we articulated our view that dollar strength would broaden out on global growth slowdown concerns and a sharp decline in commodities. This view largely played out
- However, with the Fed potentially flagging a slowing pace of rate increases and commodity markets stabilising, dollar gains could narrow somewhat. We could see dollar strength against European currencies, but more sluggish price action against pockets of the commodity bloc and emerging markets
- Within the commodity bloc, we would expect the Australian dollar to begin to show some stability, while the Canadian dollar – until now one of our preferred currencies – potentially beginning to lag behind
- Pockets of emerging market currencies, such as the Mexican peso and South African rand, could benefit from any further decline in volatility of US Treasuries
- On the other hand, we believe European currencies, including the euro, sterling and Swedish krona, will begin to display independent weakness for several reasons
- With our 1.02 EURUSD target met, we lower our three month and 12 month targets to 1.02 and 0.98 respectively, with risks to the downside. Fragilities in euro area growth, external balances and the political outlook are likely to become more of a driver.
We continue to favour further strength in the Swiss franc and remain neutral on the Japanese yen, pencilling in a broad 133 – 138 range for USDJPY. A sharp decline in fossil fuel prices and US yields would lead us to lower our USDJPY assumptions.
Following a rally over April and May, the dollar trend is getting somewhat fractured, meaning that USD strength has not only paused but is not as broad-based as it was previously.
The mood change appears to be a switch in markets: from factoring in weak growth and high inflation, to rising prospects of weak growth and moderating inflation. US 10-year yields have declined by nearly 80 bps, with all of it coming from real yields. US interest rate markets still see rates moving higher this year, but have now pencilled in 75bps of rate cuts in H2 2023.
While acknowledging this tentative change in mood, we are not altering our broader dollar outlook for several reasons.
Firstly, it remains far from clear whether a mild US recession will bring inflation down to satisfactory levels for the Federal Reserve (in turn allowing them to cut rates in 2023).
Secondly, global growth forecasts continue to be marked down. Europe’s gas supply risk, continued intermittent Chinese lockdowns with relatively modest policy stimulus, and softer US growth are all contributing. Historically, the USD (along with the JPY and CHF) has performed well in global recessions.
If we also throw in still elevated inflation and hawkish central banks, then the 1980’s experience showed us that the dollar can remain persistently strong and defy gravity (please see the introductory chart in June’s FX monthly: Weak growth, elevated inflation to support dollar).
Thirdly, our EURUSD 12-month target of 1.02 has already been achieved. Still, sentiment remains unusually neutral despite the strong declines in the pair (see chart). This suggests we are far from a “bearish capitulation” which would suggest a EURUSD bottom. With fundamentals still bearish, we revise our 12-month EURUSD target down to 0.96, while 1.02 becomes our new three-month assumption.
Elsewhere, we maintain a neutral JPY stance and would not chase the recent rapid appreciation. In emerging markets, we downgrade the Indonesian rupiah (IDR) and expect some near term recovery in the Indian rupee (INR). Following the recent Chilean peso (CLP) rally, we also downgrade the CLP to cautious, given worrying trends in the current account deficit.
To read more on our currency views and forecasts, please download our full ‘FX Monthly’ publication using the link in the top right-hand side of the screen.
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