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US-dollar performance has been mixed year to date through the end of April. European currencies (GBP, EUR, CHF, SEK) have been major gainers while commodity-linked (AUD, NZD, NOK) have been the primary decliners. The JPY has weakened, in contrast to expectation, after the Bank of Japan (BOJ) stuck to its ultra-accommodative policy stance, even as inflation printed a multi-decade high.
During the period, emerging markets (EM) central banks were well ahead of their developed markets (DM) peers, having collectively raised rates significantly. Supported by positive carry, select Latam currencies (MZN, BRL, CLP, COP) and Central & Eastern Europe, Middle East and Africa (CEEMEA) currencies (PLN, HUF) have strongly gained versus the greenback. At the same time, currencies of a weaker cohort of countries (ZAR, ARS, TRY) have underperformed due to uneven impact of geopolitics, fiscal policy, and rising refinancing costs.
We continue to have a negative outlook on the greenback as we move through 2023. Major foreign economies could outperform the US as monetary and fiscal policy settings in most countries remain less tight than the US. The Fed is closer to the end of its hiking cycle relative to other major central banks. Long-term valuation metrics still suggest USD overvaluation relative to other major currencies, and this should begin to correct as other central banks catch up to the Fed. Indeed, we think that the high relative carry on the USD has acted as a tailwind in recent quarters.
Another factor that has supported the USD in recent years has been the dominance of the US equity market, particularly driven by the tech sector. A prolonged period of higher inflation and higher rates could shift the leadership to other sectors and support global equity markets relative to the US. There has been some evidence of this in early 2023, but it is so far tentative, and recent developments in AI further call this rotation into question.
The key risks to the macro case for a weaker USD are:
What’s more, a brighter outlook for the US economy could postpone Fed rate-cut expectations and push USD depreciation back further.
Overall, despite the market forces that have supported USD in recent months, late-cycle US dynamics and the Fed pause of the end of its interest-rate-hiking cycle will likely gradually weaken the dollar from its current, relatively elevated valuation. However, this might not imply broad-based USD weakness yet, and a selective approach is required. For now, we prefer expressing dollar downside through the majors including the EUR, CHF, and potentially the JPY later this year.
US Treasury Secretary Janet Yellen recently laid out the case for why the US would consider various tools, such as export controls, restricting certain suppliers, and knocking back some foreign investment, in the context of national security risk. One of the consequences of Western sanctions on Russia has been that several trade-dependent countries have begun to seek alternative currencies to run their trading businesses while avoiding US and European Union (EU) sanctions.
While these nascent developments could impact the long-term dominance of the US dollar, to date we have not seen any other country that has the institutional infrastructure that would enable its currency to serve as a credible reserve currency or trading/settlement alternative to the greenback.
The EUR outlook has turned marginally positive, as stronger-than-expected growth will keep the pressure on the European Central Bank (ECB) to keep hiking interest rates. While US and UK fiscal policies are expected to tighten, EUR fiscal policy is still projected to be expansionary. It may be worth noting that we favor the CHF since the SNB has been encouraging further franc strength to ward off imported inflationary pressures.
Meanwhile, in the UK, resilience of recent activity and inflation data has supported GBP as rate expectations increased. However, we remain concerned about the structural vulnerability of the pound given the potential for persistent inflation and weak fiscal and external accounts.
Among commodity-linked currencies (AUD, NZD, SEK, CAD, NOK), there may be medium- to long-term opportunities. This could be especially true of currencies of DM and EM trade and commodity-linked countries whose businesses could stand to benefit from geopolitical realignments and “friend-shoring” supply chain shifts. Such beneficiaries, for example, could include Norway, Canada, Brazil, Mexico, and select Asia-Pacific countries. However, we expect a differentiated outcome across these currencies. Select central banks might slow or pause policy normalization cycles earlier because of higher interest-rate sensitivity (housing debt) of their economies — this could act as a near-term drag on their currencies.
Elsewhere, initial rhetoric from the new leadership of the BOJ has reduced market expectations of an imminent policy shift. Governor Kazuo Ueda stated that “the risk of missing our price target with premature tightening is bigger than the risk of experiencing inflation exceeding 2% due to a delayed tightening,” which suggests to us that the recently announced BOJ policy review could delay the normalization timeline somewhat.
However, we continue to believe that policy normalization is ultimately inevitable given growing evidence of a structural change in inflation and wage dynamics post-COVID. The BOJ is trying to manage tension that requires a gradual adjustment out of an inappropriate policy or risk a financial stability issue. As a result, the impact on the yen becomes more difficult (certainly not linear) as the BOJ attempts a smooth exit from ultra-accommodative policy, but ultimately this should be supportive for JPY as we go into the second half of the year.
The acceleration in global money supply across China, Europe, and Japan has more than offset the contraction in the US — this suggests near-term resilience in global DM activity indicators. Improving global growth relative to the US should contribute to broad USD underperformance. We think the broad USD index will grapple with the push and pull between structural forces, which suggests that US inflation will remain high and sticky while cycle pressures/tighter credit conditions point to a slower economy.
Market expectations for an aggressive policy pivot won’t be validated by the Fed until inflation shows further signs of decline. Therefore, we remain cautious on select DM currencies (SEK, GBP) and higher-beta EM (ZAR, MXN) currencies.
We are closely monitoring a few key signposts to evaluate the bull vs bear case for the USD from here. There are three shifts that could support the bull case for the USD. One would be a hawkish Fed response to recent US data that has surprised to the upside. Another could be a flight to quality in the face of monetary tightening. In this scenario, lower-quality entities may be especially vulnerable. And finally, if the USD looks oversold based on FX positioning indicators, we may be facing a bull case for the greenback.
We’ll also be keeping an eye out for three shifts that could prompt a bear case for the USD. The first would be improving global growth relative to the US. The second is the possibility of better-than-expected corporate earnings and the containment of the US banking sector crisis, at least for now. Third, we’ll be looking out for declining inflationary pressure, which would bring about a softer Fed stance and could contribute to the bear case for the USD.
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