Dollar strength broadens out

On the first driver, our central case scenario for the Russia-Ukraine conflict was one of “prolonged conflict” i.e. where the fighting carries on but remains largely localised to the eastern part of Ukraine. Moreover, we assumed that while concerns over reduced energy supply would keep prices higher, gas would still continue to flow to Europe.

Under this “base case” we had pencilled in EURUSD reaching 1.06. That said, recent events suggest that the possibility of moving to a worsening “war intensification and gas disruption” scenario has increased. Such a development would be even more EURUSD negative and would result in the pair breaking parity, in our view. Applying a higher probability for such a tail risk scenario, we settle on a new EURUSD forecast of 1.02, but risks are very much for further USD strength. Furthermore, our updated model estimate for EURUSD now stands at 0.98 (versus 1.05 prior), following the recalibration in expectations on US yields and the Fed's accelerated monetary policy tightening.

As for the second driver, renewed lockdowns in China, as well as signs of increasing supply-chain disruptions, have resulted in a worsening global growth outlook. While the RMB has been extremely stable over Q1, USDRMB has since risen sharply, while seeing little pushback from the Chinese authorities. We assume a 6.70 – 6.90 range for now for USDRMB, but would further downgrade the RMB view if there were more concrete signs that the country's super strong trade surplus was being affected. We view the USDRMB rise a recalibration to a broader USD strength rather than a move to devalue the RMB (like in 2015). Nevertheless, it will have negative ramifications for several currencies.

Finally, we would point out that the two developments cited above will not only pose risks to growth, but also upside risks to inflation, as they affect supply chains. Central banks have shown that they are placing more emphasis on upside inflation risks than on lower growth risks, and are likely to remain hawkish. To the extent that this results in global liquidity shrinking at a faster pace, the greenback is likely to remain very well supported. We also do not find obvious signs that there is too much USD bullishness “in the price” when we survey relevant sentiment indicators.

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