Stagflation could bring a short-term uptrend in the US Dollar

For a full breakdown of the dollar to happen, we need to see a more stark deterioration in US activity and growth indicators which seems to be somewhat off. Other factors that could propel a dollar downturn could be a stronger recovery in Chinese or European economies or clearer Bank of Japan tightening move, both of which appear to be unlikely as of now.

This suggests there may be room for the dollar to sustain some momentum for now until clearer dollar bear trend starts later when the Fed pivots. FX ranges could remain narrow in the meantime.

Looking beyond the Fed – Carry trades and China’s stimulus

As volatility remains muted, dollar carry trade still remains interesting. The most favoured funding currencies have been Japanese yen, Chinese yuan and the Taiwanese dollar. Bank of Japan’s policy tweak has not changed that and any major shifts in policy remain unlikely before the next wage negotiation results. Traders may be wary of BOJ intervention while USDJPY stays above 145, but the patience levels of Japanese authorities have likely increased.

Also, a durable dollar downtrend is hard to imagine with what’s going on in China. Economic data continues to weaken and the central bank has come in with modest policy cuts this week to provide support. Calls for more stimulus continue to escalate, but any measures so far have had little impact on confidence and demand which continue to be weak. Weakness in the Chinese economy, as well as any further easing measures, mean yuan could remain under pressure until a Chinese recovery is more evident.

Technical analysis suggests dollar bears could remain cautious

The DXY index currently trades above 103, having recovered from the July lows of 99.58 and broken above the trendline resistance as show in the chart below. Key resistance ahead at 200DMA of 103.30, but if that is broken, there could be further upside to the 104 handle. There is also still room on the RSI for further upside, bringing caution to bears.

Let’s make it actionable

Our Stagflation call could mean a short-term uptrend in the US dollar, primarily on the back of carry funding currencies such as Japanese yen (JPY), Chinese yuan (CNH) or Taiwanese dollar (TWD). Yen however remains on an intervention watch. Emerging market central banks face the most complex setup in a stagflation scenario, and EM FX may suffer as a result. Other safe-haven currencies such as the Swiss Franc (CHF) could continue to be in favour along with the dollar while stagflation plays out.

Aussie dollar remains particularly exposed to the slowing Chinese economy and the property sector issues in China. Commodity prices will likely remain depressed in a strong dollar environment, suggesting little scope for AUD to recovery until a clear recovery in China or a certain end to the Fed’s tightening cycle. Some scope for an upside surprise in Australia’s inflation remains, and this could mean markets may have to reprice the path of the RBA. NZD also faces China risks but a less hawkish RBNZ means little room for recovery.

Tactically, there could some strength in sterling (GBP) as the Bank of England may need to hike more than what the markets are pricing in for now, but structurally GBP looks weak as the central bank will likely have to force a recession to get inflation under control.