Macro: Sandcastle economics
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AUD and GBP: Potential winners of cyclical US dollar weakness
Charu Chanana
Head of FX Strategy
Key points:
- US economic data weakness is broadening, but market remains cautious of pricing in Fed rate cuts aggressively. Labor data weakness will remain the key catalyst.
- The US dollar could see further cyclical weakness if weakness in economic data fuelled further bets on a potential September Fed rate cut. USD’s high-yield and US election risks will however continue to provide an offset.
- As the USD weakens cyclically, AUD and GBP stand to gain. The Reserve Bank of Australia could stay hawkish amid inflation risks, while the Bank of England could cut rates in August but growth dynamics remain strong.
Recent weaker US economic data is reigniting speculation about potential shifts in Federal Reserve policy. Despite previous false starts, markets are cautiously contemplating the likelihood of Fed rate cuts.
However, it is hard to ignore that signs of US economic data weakness are broadening. Fed’s mouthpiece and WSJ reporter Nick Timiraos also wrote after the recent Powell testimony that the latest signs of a Fed pivot may prove more durable than the pivot seen in end-2023.
Put simply, Powell seems to be waiting for both sides of the Fed’s mandate – inflation and unemployment – to play out in slightly different ways, and the pre-conditions for a Fed rate cut seem to be:
- Continued disinflation – inflation needs to be more of the same, rather than better. Powell has said that they do not need to wait to see inflation back at 2% but just be more confident about the path leading towards the 2% target.
- Further weakness in labor market – Fed Chair Powell also noted that labor market has cooled significantly. But any risks of further cooling in the US labor market will likely be the key catalyst for the Fed to cut rates.
In essence, labor market data seems to be a more important catalyst for the Fed at this point in the cycle rather than inflation. Certainly, any higher inflation prints could still disrupt the confidence that the Fed has in reaching the 2% inflation target, but an in-line print is unlikely to be enough to push the markets to price in any more than two rate cuts for this year.
If disinflation continued, and the labor market was to continue to weaken in an orderly manner, then that could see some pressure build on the US dollar, likely bringing a round of cyclical weakness. However, the US dollar’s high-yield as well as US election risks will continue to provide an offset, suggesting that a structural decline in the USD is still unlikely this year.
But what will a cyclical US dollar weakness mean for other G10 currencies? We expect G10 currencies to remain largely a play of yield differentials. This leads us to be positive on the Australian dollar and the sterling amid the near-term room for US dollar weakness.
AUD: Reserve Bank of Australia Could Lag in the Current Easing Cycle
The RBA in the only major central bank (besides Bank of Japan) where a rate hike is still on the table. Australia’s May inflation surprised to the upside both on headline and core measures. The real test will be the June inflation print, which comes out on July 31 which will be a quarterly inflation update just ahead of the RBA’s August meeting. The RBA's latest statement on monetary policy forecasts projected an acceleration in inflation to 3.8% in 2Q24 from 3.6% in 1Q24.
The bar for another rate hike may be too high, but dilution of the hawkish stance may also be unlikely even if the expectation for Q2 inflation is missed. The long-term inflation expectations in Australia remain unanchored and unemployment rate is still quite low. Fiscal spending, especially by state governments, also continues to boost demand which remains a primary driver of inflation. This sustained hawkishness of the RBA is likely to continue to be a tailwind for the AUD, especially if the US dollar was to weaken on Fed rate cut expectations. RBA’s hawkishness also stands in start contrast to the neighbour New Zealand’s central bank that alluded to growth risks at the July meeting, signalling room on the upside for the cross AUDNZD.
GBP: Rate Cut Pace Unlikely to be More Aggressive than the Fed
Sterling's bullish run in H1 came on the back of improving economic momentum. Political stability has given further room to sterling to extend its dominance over other G10 currencies, especially as it comes in a sharp contrast to the unstable political developments in other parts of Europe. The next big point of concern for the British pound is whether the Bank of England will cut rates in August or not.
Two of the BOE’s rate-setters are already voting for cuts — Swati Dhingra and Deputy Governor Dave Ramsden. External rate-setters – Catherine Mann, Jonathan Haskel and Megan Greene – appear to be unlikely to back an August cut. It leaves the decision hinging on four remaining internal rate-setters. Chief Economist Huw Pill spoke this week, and sounded relatively hawkish, signalling he may not join the rate cut camp in August. Governor Andrew Bailey said before the pre-election blackout period that rate cuts could come before the Fed. He holds sway with other MPC internal members as well, particularly Sarah Breeden. Clare Lombardelli is the new MPC member replacing Ben Broadbent and may be bit of a wildcard. If she was to join the rate cut camp, that would make it 5-4 vote in favor of a cut. In summary, an August BOE rate cut still remains a possibility. Much will depend on the June inflation print due on July 17, especially services inflation, and the May wage growth numbers out on July 18.
This means GBP could be vulnerable next week especially if data suggested further possibility of a BOE rate cut. However, medium-term dynamics are worth considering. Currency concerns will continue to limit the extent to which other central banks such as ECB and BOE can diverge from the Fed. UK’s inflation is also expected to rise again in H2, suggesting the pace of rate cuts from the BOE will unlikely be aggressive. The BOE will maintain a rate cut pace aligned to, or slower than, the Fed.
It is also worth noting that any rate cut in the UK is likely to come from inflation dynamics cooling, rather than any demand-side concerns. This continues to bode well for the sterling, despite near-term risks. As such, sterling could remain one of the cyclical beneficiaries of US dollar weakness in the next few weeks.
Disclaimer:
Forex, or FX, involves trading one currency such as the US dollar or Euro for another at an agreed exchange rate. While the forex market is the world’s largest market with round-the-clock trading, it is highly speculative, and you should understand the risks involved.
FX are complex instruments and come with a high risk of losing money rapidly due to leverage. 65% of retail investor accounts lose money when trading FX with this provider. You should consider whether you understand how FX work and whether you can afford to take the high risk of losing your money.
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