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Global FX: US dollar gains to prove temporary, assuming global risks subside

The market’s bid for the US dollar remains strong. But as uncertainties recede from mid-year, the trend is expected to reverse.

9 May, 2022

Midway through our commentary last month, we emphasised that our baseline expectation for the US dollar to begin a downtrend in coming months was predicated on an assumption “that risks related to Ukraine dissipate through 2022”. The past month has been completely counter to this tenet however, with Russia threatening to halt the supply of gas to Europe unless purchasers pay in Rubles while European authorities introduced yet another round of sanctions -- including a planned phasing out of Russian coal and oil imports. The fighting across large parts of Ukraine has also continued and, seemingly, there is no end in sight to the conflict.

From 99.9 at the time of our last release, the US dollar index leapt to a high of 104 mid-month, a level it continues to trade near, currently 103.9. US rate expectations at fever pitch and the market’s acute concerns over China’s COVID-zero policies have also supported the US dollar.

Whereas a month ago, we expected the DXY index to trade at 99.0 in June and 97.4 come December, now we forecast 102.1 and 100.2 respectively. However, our end-2023 forecast is still around 95.5.

Obviously, key to both the US dollar’s historic strength now and in the period ahead is weakness in both Euro and Sterling. For Euro, it is not only the immediate impact of the conflict on growth that matters (see page 20 of our May Market Outlook), but also the consequences for monetary policy.

Some in the market believe the ECB may raise rates by year end; we instead expect a few more months will prove necessary to make the case. Regardless, the starting point for the ECB is -0.50% against a fed funds rate currently at 0.875% on its way to 2.625% come December. Moreover, the probability of a rapid fire tightening cycle by the ECB remains extremely remote. On this point, note that the spread between the German 10-year Bund yield and the US Treasury’s 10-year yield is currently close to -200bps and only expected to come in to –140bps by end-2023.

Ahead of their May meeting, the growth and policy view was thought more favourable for Sterling, but with the Bank of England now forecasting 10%yr inflation in 2022 and no growth in 2023, the market is rightly concerned. Further tightening by the BoE is likely to be much more modest than in the US and, given the growth consequences, at best neutral for the currency.

The circa 3.5% appreciation forecast for Sterling and Euro to year end is therefore set to rely more on risks to the regional outlook dissipating and a broadening of the global recovery, both increasing opportunities for investment and greater consumption of durables -- spending long held back by supply chains and the uncertainty clouding the global outlook. Through 2023, we see a continuation of this trend against the US dollar, from USD1.27 to USD1.34 and USD1.09 to USD1.15 (+5.5%). Of the two currencies, if the downside for the Continent from Russia’s invasion of Ukraine were to reverse, Euro would outperform over the period.      

When assessing the DXY trend, it is also important to recognise that the US dollar’s recent gains have not only come as a result Euro and Sterling but also Japan’s Yen. Over the period, USD/JPY has risen from JPY124 at the time our April Market Outlook to a mid-month high of JPY131. This has occurred primarily because, over the period, the Bank of Japan were as committed to holding interest rates down and continuing to expand their balance sheet as the FOMC was to doing the opposite. The 10-year yield spread between Japan and the US is a staggering 290bps as a result, and unlikely to narrow materially for the foreseeable future.

With the high price of energy also set to continue weighing on Yen thanks to Japan’s reliance on imported fuels, Yen is only expected to see a partial recovery of 2022’s depreciation from USD/JPY114, with USD/JPY forecast to fall from JPY130 to JPY121 end-2023.

In stark contrast, the developing nations of Asia still hold considerable promise, particularly China. For all the headlines touting wide-spread economic malaise under the weight of authorities’ COVID-zero strategy, USD/CNY has only marginally disappointed against the US dollar trend this month. Meanwhile, available data continues to speak to resilience, and the talking points of policy makers to promoting investment in pursuit of long-term growth and prosperity.

To be sure, we believe that the restrictive approach taken by authorities has to change -- preferably quickly given the low incidence of material health concerns but significant damage to sentiment. However, we also have to recognise Chinese authorities have an unparalleled capacity to quickly turn their economy through stimulus and co-ordination across all levels of government. If our growth view proves correct, see page 18 of our May Market Outlook, then CNY6.35 and CNY6.15 at end-2022 and 2023 respectively are readily achievable.