investment insights
Too far, too fast? The dollar in decline
Key takeaways
- Recent US dollar weakness is largely due to differing central bank policies
- Currency markets may have overreacted in the near term, with the USD remaining a relatively higher-yielding currency as other central banks also cut rates
- The Swiss franc and Japanese yen are poised to outperform the USD, while the euro and sterling face headwinds, and demand a cautious approach
- Sharp recent market moves should not be extrapolated. A year from now, we see EURUSD at 1.07, GBPUSD at 1.23, USDJPY at 135 and USDCHF at 0.84.
Recent weeks have seen intense investor focus on the US dollar’s weakness against other major currencies. That is largely explained by differences in central bank policies and, we argue, demands a rather nuanced outlook on the US currency.
The DXY dollar index, a key gauge for the US dollar against advanced countries, has fallen over 4% since the end of June, taking it towards the bottom of this year’s trading range. The main reasons for such a sharp fall include markets pricing an increasingly dovish turn in Federal Reserve policy, as well as lower probability of a Republican US administration, which is typically considered USD supportive, after President Joe Biden stepped down from the race.
While Fed policy could be considered restrictive, the same applies to the European Central Bank (ECB) and the Bank of England (BoE). As other central banks also cut rates, the USD will remain a relatively higher-yielding currency. As we wrote in July, this has been a key anchor for the DXY dollar index, highly exposed to cyclical currencies like the euro and sterling that together account for 70% of its weighting. Both the ECB and BoE have started easing monetary policy, and their economies are exposed to softer global growth, particularly in China.
It’s also worth noting that in past easing cycles the EURUSD pair has seen limited follow-through after a first Fed cut. Accordingly, we believe it is prudent not to extrapolate recent sharp movements in currency markets.
Which dollar? A case-by-case approach
For simplicity, the US dollar is referred to as a single entity. In reality there are many “dollars.” The DXY index looks at dollar rates against six developed market currencies, while the Bloomberg dollar index (BBDXY) takes into account 12 developed and emerging market currencies. Since the Great Financial Crisis, performance dispersion of these currencies against the US dollar has increased, driven by country-specific fundamentals. This means that to make sense of the USD’s movements, investors need to marry “bottom-up” analysis with a “top down” view.
As the Fed embarks on its easing cycle over the year ahead, we believe that investors need to take a more nuanced stance on the USD. Currencies like the Swiss franc (CHF) and Japanese yen (JPY) can outperform the USD, while the euro (EUR) and sterling (GBP) will remain relatively weaker.
Euro and sterling – cause for caution
Recent rallies in the EURUSD and GBPUSD are due to markets pricing in a much steeper Federal Reserve rate cutting cycle compared with other developed market central banks. Markets now price in close to 250 basis points (bps) in Fed rate cuts until the end of 2025, compared with about half that amount for the ECB and BoE.
Can this spread in expectations between Fed policy and the ECB and BoE widen over the coming quarters? One factor is that the Fed has access to more timely economic data, and a dual mandate to stabilise both prices and the US job market; it has signalled a shift in emphasis on the latter. In comparison, the primary focus of the ECB and BoE is inflation, and they work with less frequent labour data. However, today’s pricing divide proves the limits to this argument. We see the Fed, ECB and the BoE as being on a similar easing cycle, with higher terminal rates for the US than the euro area and the UK.
Why is this important? Historically, a relatively lower-yielding euro against the US dollar has been a key determinant for where EURUSD eventually lands (see chart 1). Today’s yield suggests that a lower-for-longer EURUSD range is appropriate. Recent exceptions were periods when global, European and Chinese growth were recovering briskly (such as in 2017-2018 when the EURUSD rallied sharply despite a wide spread between US and euro area interest rates). Today, the outlook for China is less promising with authorities refraining from aggressive stimulus measures (see chart 2). This suggests a more cautious stance for both the euro and sterling against the US dollar is appropriate.
While market expectations have risen for a Democratic US Presidency, supporting EURUSD, we believe it is still early days. There is a historical pattern of more positive US dollar trends ahead of US presidential elections, as markets price in greater uncertainty ahead of the event. As for election scenarios, we believe a Republican White House and a Republican sweep of Congress would be negative for EURUSD, with a lower 1.01 to 1.06 range appropriate. On the other hand, a Democratic administration would be neutral-to-modestly negative for the dollar, resulting in a higher 1.08 to 1.13 range (see our recent CIO Office Viewpoint for more detail). We assume EURUSD at 1.09 and 1.07 in three and twelve months respectively.
Sterling has held up well this year, benefitting from its new-found status as one of the highest-yielding currencies. That said, the UK’s external balances remain weak and, while relationship with the European Union may improve somewhat, we see little prospect for major changes to its trading arrangements with the bloc. With sentiment already positive, further BoE rate cuts will cap sterling’s appreciation at some point. We assume USDJPY at 149 and 135 in three and twelve months respectively.
Swiss franc and yen strength
On the other hand, excluding any short-term volatility, we believe the outlook for the lower-yielding safe-haven Swiss franc and Japanese yen look brighter a year from now. With the Swiss National Bank (SNB) having limited room to cut policy rates and the BoJ gradually tightening policy, lower global policy rates should benefit both currencies.
The Japanese yen has been at historically cheap levels for nearly two years, but the BoJ’s reluctance to normalise monetary policy meant the currency lacked a catalyst for a recovery. With the Fed now closer to cutting rates and the BoJ normalising still-negative real policy rates, the USDJPY should decline closer to its fair value of around 135 (see chart 3). The path to a stronger yen will be volatile since the currency is sensitive to changes in US yields, and potential capital outflows, given Japan’s trade deficit. We assume USDJPY at 149 and 135 in three and 12 months respectively.
In contrast, the Swiss franc looks both strong and appropriately valued (chart 4). Typically, for small-open economies like Switzerland, signs of cracks in the trade balancecan indicate that currency appreciation has reached overvalued levels. However, despite the franc’s strength, Switzerland’s trade surplus has remained robust. This is due to the high-value nature of its exports, such as pharmaceuticals, which are less sensitive to exchange rates.
A strong trade surplus implies natural support for the Swiss franc as exporters’ purchases of the Swiss franc outweigh importers’ franc-denominated sales, assuming there are no significant capital outflows. However, from 2009 until 2021, the SNB was the main generator of outflows through large Swiss franc-selling interventions. The threshold for the SNB to repeat such interventions now looks high compared with the past, and the central bank’s already-large balance sheet exceeds 100% of the country’s GDP. We assume USDCHF at 0.88 and 0.84 in three and twelve months respectively.
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