Upside risks to euro-dollar are rising

Despite historically strong positive US dollar seasonality, May has so far seen the dollar to continue its slide. Declines in US real yields, paring back of Federal Reserve (Fed) rate hike expectations, and misses in a number of important US data releases (ISM and non-farm payrolls) have all contributed to USD weakness. We maintain the view that the dollar is likely to depreciate further on a multi-month basis. This is based on the sharp global recovery, the Fed remaining accommodative on the face of transitory upside inflation surprises, and the dollar’s overvaluation.

As discussed previously, the main risk to our bearish USD view is another abrupt yield increase without the Fed pushing back against it. However, we do not think this is very likely in the immediate future. The inflation pick-up will mostly be transitory and due to sizeable base effects. Consequently, Fed officials will look through these short-term fluctuations and will be in no hurry to contemplate the tightening of monetary policy.

Regarding EURUSD, we maintain our forecasts unchanged, but highlight that risks have now moved firmly to the upside. The key reason is the pick-up in the EU vaccination programme, which is leading the market to price out the initial pessimism. EURCHF is likely to trade in a range of 1.10-1.12 for the rest of the year – although risks here too have moved to the upside.

Turning to sterling, we do not share the recent market euphoria generated by the result of the Scottish election. We still expect structural Brexit-related headwinds to maintain pressure on the GBP. Overshoots are always possible, but we think that eventually GBPUSD will settle between 1.38 and 1.40 by year-end. The main risk to this view is an earlier tightening of monetary policy by the Bank of England.

Dollar-yen has maintained its very slow decline. We expect this to continue due to valuation, an improved Japanese trade balance, and ongoing equity outflows from Japan.

In the Nordics, we reiterate our preference for the Norwegian krone (NOK) but expect that in the near term, NOK gains may slow. In the core commodity FX bloc, we think current Australian dollar levels are still attractive to express the reflation theme. The Canadian dollar should remain supported by global and domestic developments, but the move higher is likely to slow considerably given that a lot is already in the price.

Since the beginning of the year, the GBIEM benchmark EMFX index has been flat in USD terms, largely reflecting the moves in the US dollar. Over June, we would expect emerging market currencies to hold up reasonably well, with widening EM-US data surprises providing support. It helps that tail risks for many currencies with large weights in the index (RUB, ZAR, BRL, MXN, and IDR) have seen a tentative decline in perceived fiscal and political risks.

That said, we would become more cautious from August onwards as the EM-US relative growth is set to tighten and as markets focus more on the possibility of the Fed tapering.

We maintain our “rotation to select EMFX” theme, with the renminbi remaining our top pick as risks there seem manageable. This month, we upgrade the Russian ruble, Mexican peso and Brazilian real, but downgrade the Indian rupee, Thai baht, and Chilean peso.

Main risks to our view: The main upside risk to our forecasts comes from a stronger recovery in global trade, which would send the US dollar into an even steeper decline and support bigger and broader rallies in the G10 and emerging markets. On the downside, we see the following risks: first, further rapid increases in US yields. Second, the Fed turning less dovish and so triggering a market reaction like 2013's "taper tantrum". Third, further delays in the distribution of Covid-19 vaccines that would increase the risk of prolonged restrictions and economic disruption. Fourth, a premature withdrawal of global fiscal support.

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