FX Talking: Go your own way
Sticky US inflation has prompted quite the sell-off in US rates and seen the dollar strengthen broadly. At the same time, central bankers outside of the US are expressing their policy independence and talking of summer rate cuts. It looks like policy divergence and higher FX volatility will be the story of the quarter. We are raising our dollar forecasts
A month can seem like a long time in the world of FX, but over the last month, the dollar has taken a decisive turn to the topside. Three months of core US inflation at 0.4% month-on-month has put paid to any thoughts of early Federal Reserve easing. At the same time, downside surprises in eurozone inflation have firmed up views that the European Central Bank can pursue its own path to eurozone happiness by starting an easing cycle in June. This quarter, expect to hear frequent use of the term ‘divergence’ and how much it will drag EUR/USD lower.
On the back of adjustments in the house Fed view this month – we now only look for three Fed rate cuts this year with the risk of two – we can no longer make the case for EUR/USD to trade above 1.10 over the next 18 months. We have cut our EUR/USD profile, but have not turned outright bearish – not unless Fed rate cuts are completely abandoned or geopolitics delivers a substantial spike in energy prices.
Away from EUR/USD, we note FX volatility finally trading higher as we approach likely USD/JPY intervention levels. Within G10 it is starting to look more interesting with central banks in Canada and Sweden potentially joining the ECB with rate cuts this quarter.
In the EM world, we continue to prefer the Polish zloty where EU transfers and a less dovish central bank should dominate. We are more worried about high yielders like the rand ahead of elections in late May. There is also much focus on whether China will allow notable depreciation in the renminbi. We think not. And in Latam, Mexico’s peso should hold gains, while Chile’s peso is vulnerable now that local rate cuts look too aggressive.
