16 May 2023

FX Talking: The rocky path to a weaker dollar

Tighter US credit conditions caused by the banking crisis will make a recession and a deeper Fed easing cycle all the more likely. These events strengthen the case for a weaker dollar. We are raising our year-end EUR/USD forecast to 1.20. The path to a weaker dollar will be a rocky one, however. Any breakdown in US money markets could send the dollar stronger

Executive summary

What seems clear from events over recent months is that US credit conditions are tightening and that this will weigh on US growth prospects. So far, the Federal Reserve has yet to formally quantify the impact of these developments, but our team forecasts that they are enough to curtail the tightening cycle and prompt 100bp of easing in the fourth quarter.

We argue that Fed cuts later this year should prompt a multi-quarter – probably multi-year – cyclical dollar decline. And given the strained geopolitical backdrop, cyclical dollar weakness may well get confused with the structural dollar decline associated with the de-dollarisation story.

Our year-end targets for EUR/USD and USD/JPY now sit at 1.20 and 120, respectively. As we have argued in prior FX Talking publications, we expect the bulk of the dollar decline to occur in the second half of this year – a view premised on clear signs of US disinflation emerging and a successful resolution to the US debt ceiling stand-off.

Before then, however, we suspect financial market tension will rise. Were political miscalculations in Washington to be made, we fear any seizure in the workings of US money markets could trigger the kind of flash crashes in EUR/USD seen in 2008/2009 and most recently in March 2020. Sub 1.05 levels in EUR/USD would certainly be possible if wholesale USD funding markets became impaired. Any such losses would prove temporary and would be quickly reversed when the Fed – and politicians – restored order.

Looking across the G10, we would therefore reiterate our call for the outperformance of the defensive Japanese yen and Swiss franc over the next couple of months – especially were the Bank of Japan to normalise policy at its June meeting. Equally, it may be too early to look for a sustained rally in the high beta currencies in the commodity bloc and in Scandinavia. Sterling has been doing well, but we still feel the market has pried too much Bank of England tightening – leaving sterling vulnerable.

In the EMEA space, implied yields of the CE4 currencies remain attractive – although the case for central bank easing looks to be building. We think they can mostly hold onto recent gains. Elsewhere, Turkish financial markets look with interest to the Presidential run-off on 28 May.  And a new geopolitical front has opened up in South Africa, where the US has accused it of shipping arms to Russia. This may demand a lasting risk premium of the South African rand.

In Latam, the Mexican peso continues to advance. It offers the highest risk-adjusted carry in the Emerging Market space and will also continue to be buoyed by increased FDI prospects from the ‘nearshoring’ story. The Brazilian real is also performing well. Yet gains look more fragile here and any backsliding on fiscal reform or undue pressure on the central bank could prompt the real to hand back recent gains.

And lastly, in Asia, north Asian currencies in particular remain out of favour. Whether that is being driven by concerns over Chinese growth, weak export markets or the semi-conductor cycle remains to be seen. Our call is for a second-half recovery in most Asian currencies – premised, however, on a broadly weaker dollar.

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