FX: Risk-on currencies to surge against havens

USD: Bulls may not fully give way

The US economy has proven remarkably resilient, constraining the Fed and keeping the USD supported for much of the second quarter. However, as we argued in the Q2 outlook, the signs of fading US exceptionalism have diminished the greenback's allure towards the end of the second quarter. 

Heading into Q3, Fed easing remains a question of “when” and not “if.” More importantly, considering the two-lane economy theory discussed in our macro outlook, a slowdown in some parts of the US economy is expected to be measured. However, the US election backdrop could lead to "sandcastle economics," where the Fed may lean dovish at the slightest signs of economic weakness rather than turn hawkish amid risks of bumpy disinflation.

This suggests a dollar-bear trend will persist into Q3. The G10 rate cut cycles are also likely to align more closely in Q3 compared to Q2, where the Fed maintained a hawkish tone while the SNB, Riksbank, Bank of Canada, and ECB cut rates. These central banks may have initiated easing, but there are limits to how far they can diverge from the Fed.

Still, risks to the USD are more balanced now that valuation and stretched long positioning have somewhat corrected. The US dollar’s high yield remains a supportive factor, with the rate cut cycle expected to start slowly unless the US economy faces a credit event. Safe-haven demand is also likely to persist ahead of the US elections.

Risk-on currencies: Selective outperformance over havens

High beta currencies, or currencies that are highly sensitive to changes in global risk sentiment and economic conditions, are likely to outperform in a dollar-bear environment. These include Scandies (SEK and NOK) and antipodeans (AUD and NZD). AUD and NZD remain well-positioned, as their central banks are likely to continue to lag the rate cut cycle, and the stabilising China economic picture is underpinning commodities and commodity currencies. Meanwhile, the Canadian dollar (CAD) could remain under pressure due to hard-landing risks for the Canadian economy, despite the Bank of Canada starting its rate cut cycle.

Low-yielding currencies such as JPY and CHF are likely to underperform in a dollar-bear world due to negative carry. The Japanese yen remains in focus amid risks of carry trades unwinding as we move closer to the Fed’s rate cuts and given the Bank of Japan’s attempted hawkish posturing. We continue to expect the BOJ rate hikes to fall short of the rhetoric, and unlikely to be enough to strengthen the yen, but tighter risk management on short yen positions may be warranted given the Fed easing expectations. 

EM FX: Tactical and prudent carry strategies

The FX volatility index remains close to two-year lows and could stay low, as markets anticipate cautious softening in the Fed stance during the summer. The emerging markets election calendar has also peaked, suggesting room for volatility to remain low.

This means carry trades could remain popular, but some of the most popular carry plays, such as those funded in JPY, are starting to see realised volatility pick up. Yield spreads will also weaken as rate cut cycles in G10 and emerging markets go further, and US elections could fuel volatility into the end of Q3. As such, carry stance should be more tactical and with tighter risk management. With Mexico, South Africa and India’s elections out of the way, MXN, ZAR and INR could remain favoured target currencies, but post-election uncertainties remain. For funding these carry trades, JPY’s low yield is unlikely to be deterred by BOJ’s modest rate hikes, while EUR could become a funding currency as well if growth remains precarious and ECB rate cuts pick up pace.