FX Talking: Weatherproof markets

Unlike the old market adage of ‘sell in May and go away’, it looks like investors will be heading off to the beach this summer overweight risk assets. This is largely being driven by the AI super-cycle and a view that both the US and Iran want a near-term peace deal. The risk over the next couple of months, however, is that the fallout from this year’s stagflationary shock lands in financial markets and the dollar stays stronger for longer.

With inflationary pressure set to intensify over the next quarter, currency trends will continue to be driven by the central bank reaction function. The G10 winners are proving and will continue to prove the currencies of Norway and Australia, buoyed by high rates and a good export mix. Underperformers will be those currencies with negative real rates and on the wrong side of the commodity ledger – notably the Japanese yen.

The dollar has delivered a middling performance so far but could enjoy some short-term gains as the market temporarily prices a Federal Reserve tightening cycle. Even though we expect a European Central Bank hike in June, EUR/USD could test the 1.15 region again as US inflation picks up at a time of stable US activity. But the house call of the US economy slowing this year, a risk premium re-emerging ahead of November midterms and a Fed cut in December means that we retain a 1.20 EUR/USD forecast for year-end.

Elsewhere, sterling faces a long hot summer of political risk, which could add to an already vulnerable picture. Talking of politics, we expect demand for Hungarian assets to remain strong after recent elections and also see the Czech koruna as a good store of value in Central and Eastern Europe.  In Asia, the North-South FX divide is expected to continue and in Latin America, we think Brazil’s high implied yields can keep the real strong despite local politics.