US Dollar: The upswing has begun

Dollar serves as an insurance in recessions

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.

Supplementing returns with carry

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.

Return of the geopolitical tensions

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.

Market implications

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.