FX Talking: Disinflation trade hits a speed bump

Strong US jobs data and a higher-than-expected January CPI number have unnerved the disinflation trade in FX markets – namely, that of a benign decline in the dollar. Federal Reserve officials accept that the disinflationary path will be a ‘bumpy’ one. However, our economists retain a view that inflation will remain on track towards policy targets. If that is the case, current dollar strength may only last another month or two.

For the FX benchmark EUR/USD, that probably means that the downside is limited to the 1.05/1.07 area this month; recall that January and February are typically strong months for the dollar. We continue to expect a modest rally this summer and EUR/USD to end the year somewhere near 1.15. We will be discussing more on US election scenarios over the coming months. And risks are building that USD/JPY pushes higher still.

Elsewhere in G10, we continue to favour the high beta Scandi and commodity currencies when the dollar trend does turn lower. Before then, commodity currencies in general may take some notice of the China Two Sessions meeting in early March for signs of stimulus. Sterling faces an event risk of a pre-election budget in early March. Any misjudgement of fiscal risks by the UK Chancellor could see sterling suffer.

Emerging markets have largely been characterised by low volatility. Polish and Hungarian currencies should continue their diverging performances. South Africa’s rand faces a big event risk from the budget this month. We think investors will favour the Mexican peso and perhaps now the Brazilian real too. And Asian FX should stay soft until global rates fall decisively again or China surprises with stimulus.