Chief Investment Strategist
Summary: Treasury yields and dollar trajectory took a turn over the last week with economic data out of the US proving to be resilient. This has allowed the market to better absorb Powell’s message on further rate hikes and higher-for-longer, though still not fully so. The upswing in the dollar may have only begun if you consider the room for the markets to adjust to this new hawkish narrative, and gains could also extend further in H2 if non-US recession concerns deepen. With volatility staying low, dollar also provides a good carry and the path of least resistance appears to be going higher.
The path of the US dollar has been purely a function of the Federal Reserve policy expectations over the last two years. As expectations of a tighter policy ramped up, the USD gained strongly over the course of 2022, peaking eventually in September at a 20-year high. Since then, inflation in the US has been cooling, and expectations of a Fed pivot have been rampant. This drove the USD lower, with most gains coming in GBP and EUR, where the rate hike cycle is expected to be longer than the US.
The setup going into H2 however appears to be somewhat different. For one, investors have positioned for the end of the rate hike cycles somewhat prematurely, and second, there will be hovering risks of a slowdown or a recession as central banks continue to tighten. A few considerations could be important to assess the path of the US dollar from here.
The global central bank divergence has started to widen. While the Fed paused in June, Bank of England hiked rates by 50bps and the European Central Bank is expected to hike rates by 25bps. However, the market’s interpretation of rate hikes is now changing, with more rate hikes spelling cause of concern as inflation remains unanchored. This means more rate hikes wouldn’t necessarily translate into stronger currencies now. This was evident with the larger-than-expected rate hikes from Bank of England and Norges Bank last week, which failed to translate into stronger GBP or NOK by the end of the week.
Meanwhile, the market is still complacent about Fed rate hikes, with only another 35bps of rate hikes being priced in by the markets as against Powell’s message of two or more rate hikes, which suggests continued scope for a hawkish shift. With the Fed having paused in June, it is now being seen to be taking a measured approach without the sense of urgency that some of the other central bankers have that have been behind the curve (ECB, BOE and RBA).
As the rate hikes from the global central banks filter through to the economy, there is likely to be rising risks of an economic slowdown. Even as the markets are currently looking more positive h as the banking crisis and debt ceiling risks having been averted, but focus on economic data will likely be back in H2. That said, any recession in the US is likely to be shallow as household and non-financial corporations’ balance sheets remain relatively healthy.
Recession risks are more pronounced for UK or the Eurozone, which need to hike more aggressively, likely bringing a recession to their economies to get a handle on their inflation which still remains above US inflation. Earlier in the year, it appeared that that growth numbers in Europe and China would accelerate and widen the gap against the US. However, that has not played out, and recession risks remain more prominent outside the US. This could spur demand for the safe-haven dollar.
With markets traditionally quieting down significantly over the incoming summer months, it can be expected that implied and realised volatility could continue to decline. Meanwhile, yields are expected to remain high, and that could bring back interest in FX carry trades where investors borrow in low–interest rate currencies to invest in high–interest rate currencies and pocket the spread. US interest rates are now high compared to the extremely low (or negative) rates in countries like Japan or Switzerland. This could bring USD carry trade in focus with the US economy still looking healthier than most other countries, as against EM carry trades that are usually in focus in case of a higher chance of a US-centric recession.
Last weekend’s reports of Russian mutiny have brought geopolitical concerns back on the table. While an immediate threat to Putin has been averted with the situation being de-escalated, there remain risks of renewed tensions as Putin fears losing his grip. The incident has exposed the underlying instability in the geopolitical world order, and will likely boost safe-haven appeal of the US dollar. More so, geopolitical tensions have also been aroused again this week in the semiconductor industry with US adding to its export curbs of chips in several ways including new chip designs and technologies.
The dollar upswing has begun, and has room to run. FX is a relative game, and buying dollars will mean selling another currency. AUD may remain the most exposed, given that the Reserve Bank of Australia appears to be favouring a pause after its two surprise rate hikes recently. China stimulus measures have remains slower and more measured, disappointing those looking for a significant growth push. CNH also remains vulnerable to slowing China growth.
The key risk to consider could be a sudden move by Japanese or China authorities to support their currencies that have been witnessing a rapid pace of deterioration recently. A sudden pullback in liquidity could also disrupt the near-term USD strengthening trend.
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Chief Investment Strategist
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