USD Strength Hinges on Policy Stance

The broad soft- or no-landing macro theme in March lifted equities and commodities, while yields dipped. Currency markets, shaped by central bank shifts, saw the USD rise on US growth and Fed projections. Tactically, we are now neutral to slightly negative on the CAD.

In the near term, we expect more of the same: currency markets are likely to continue to trade within fairly tight ranges — anchored by a range-bound US dollar, which is currently stuck around its 15-month average level against a broad basket of G10 currencies. Additionally, we expect that the US dollar movements within that range will be largely driven by factors underlying relative monetary policy expectations, as they were during March. For that reason, we are also likely to see ongoing sensitivity to country-specific growth and inflation data, as those drive monetary policy. In that regard, we see some skew in potential near-term market moves for certain currencies.

Rising global growth estimates and higher-for-longer yields favor a continuation of the carry trade — buying high-yielding currencies versus low-yielders. With the increased risk of Japanese intervention to support the yen and the Swiss National Bank (SNB) cutting rates, we expect a rotation toward the Swiss franc serving as a funding currency for carry trades — potentially having a negative impact on the franc.

We also see a likely skew in investor sensitivity toward inflation and growth data. To date tighter policy has supported the US dollar. Investors and central banks are highly focused on when to start easing monetary policy. Now with expectations reset, we suspect that any downside surprise in growth and inflation will likely trigger a correction lower in the US dollar. Finally, if we observe a local peak in G10 yields and Chinese economic data continues to show signs of stabilization, there is room for extreme pessimism regarding the yuan to abate. This would likely limit downside and allow some recovery in yuan-sensitive currencies and commodity prices, mostly the Australian and New Zealand dollars.

US Dollar (USD)

We have long held the view that the US dollar is likely to fall at least 10–15% over the coming years, but is currently in a noisy transition period from a bull to a bear market in a protracted range-trading environment. We recommend long-term investors to hedge a healthy portion of their US dollar exposure; US investors, on the other hand, should consider cutting back on foreign currency hedges.

For those with a shorter, tactical horizon, we believe the dollar will remain well-supported in a range-trading environment, at least over the next few months. The G10-leading US growth and interest rates provide strong near-term support, further underpinned by the tendency of the dollar to rise in times of stress, serving as a nice insurance policy should an unforeseen shock derail the current soft or no-landing scenario. There is room for a modest upside over the coming months.

That said, the dollar is now more than 22% above our estimates of long-run fair value and the market has already reduced the number of expected rate cuts from around 6 to around 3 for 2024, aligning with the Fed projections. The US dollar is optimistically priced and vulnerable to a temporary sell-off.

Canadian Dollar (CAD)

We are neutral to slightly negative on the Canadian dollar relative to the G10 average, but see it struggling versus the yen and the US dollar. The Bank of Canada (BoC) is likely to cut rates by the summer— in line with expectations for most central banks — preserving the Canadian dollar’s position as one of the higher yielders in the G10. However, lower growth and faster disinflation relative to the US are likely to provide the BoC with greater scope to ease monetary policy relative to the Fed. This is likely to keep the Canadian dollar depressed relative to the US dollar for the next quarter or two.

In the long term, looking through the weaker cyclical picture, the Canadian dollar looks more attractive as it is cheap to our estimates of fair value relative to the euro, the Swiss franc, and the US dollar; and its long-term potential growth is poised to improve on an aggressive increase in immigration and substantial plans to invest in sectors such as green energy technology.

Euro (EUR)

We maintain a neutral view on the euro against the G10 average, but a negative view against the US dollar and the yen. This is not a favorable environment for the euro as the combination of ongoing European Union (EU) stagnation and expectations of European Central Bank easing by June is likely to weigh on the currency. Offsetting that negative force is the robust labor market, which may keep the ECB on the sidelines past June and/or slow the pace of policy easing. Additionally, it appears that investors may be overly pessimistic on EU growth prospects. Economic data shows ongoing stagnation, but it has been coming in above pessimistic market expectations, which is favorable for ongoing euro stability.

British Pound (GBP)

Our factor models are slightly negative on the pound versus the G10. We expect the pound to remain in a range with a slight negative bias. The positive UK growth surprises relative to weak expectations and presumed Bank of England (BoE) caution to cut rates may have been enough to lift the pound from deeply discounted territory during Q1, but the more recent economic data is no longer surprising in a positive direction. We see risks to the pound from the near-stagnant economy, disinflation (transition to monetary easing), and the growth constraints from high fiscal and current account deficits.

Our long-run valuation model has a more positive outlook for the pound, as the currency appears cheap to fair value. But we expect sticky inflation and chronically weak potential growth post-Brexit to likely weigh on fair value, somewhat limiting that potential pound upside over the next several years.

Japanese Yen (JPY)

Our models have maintained a positive view on the yen relative to the G10 but retain a negative view versus the US dollar, given high US interest rates and strong relative growth, and the dollar’s superior recent performance as a safe-haven. The recent trend to push out expected global monetary policy easing is likely to keep global yields higher and the yen on the defensive for longer, but we see risks skewed toward a broad yen recovery later in 2024.

We expect global yields to peak and turn lower, while below-trend global growth (maybe only returning to trend in the US) should increase the chance for periods of volatility in risky assets. However, that may take a while as inflation and growth remain more resilient than expected. Until we see a more definitive turn lower in global yields, the yen is likely to remain weak. Still, we see further weakness as limited due to the increasing threat of currency intervention.

Swiss Franc (CHF)

We are negative on the franc over the strategic horizon. Tactically, our very short-term fair value model sees potential for a quick, temporary rebound. Beyond that the franc remains the most expensive G10 currency per our estimates of long-run fair value, has the second lowest-yields in the G10, and inflation is falling faster than expected.

With the real-trade weighted franc near 30-year highs, any further strength could easily induce the SNB to intervene — to weaken the franc, consistent with its March rate cut. We believe we are in the early stages of a prolonged reversion back down toward our estimate of its longer-term fair value, though we also likely need to see further stabilization and early signs of recovery in the EU economy and further yen upside to accelerate the move.

Norwegian Krone (NOK)

Our short- and medium-term models remain negative on the krone but much less so than last month, as the result of stronger growth expectations, higher oil prices, and improved local equity market performance. The relatively more hawkish Norges Bank policy stance is also an important support, though it does not appear to have impacted the currency to date. That said, we continue to have important near-term concerns which keep the tactical signal negative. Equity markets appear overextended relative to potential global growth and political risks; at the very least, they may experience a temporary (some would say healthy) pullback. The krone is usually quite sensitive to equity downdrafts.

In the long term, the outlook is more convincingly positive. The krone is historically cheap relative to our estimates of fair value and is supported by steady long-run potential growth.

Swedish Krona (SEK)

Our models are neutral on the krona over the near term. Growth has been chronically weak but is showing some signs of improvement, especially versus depressed expectations, very much like the broader EU. This stabilization in the context of the historically cheap krona valuation suggests recovery.

However, any resulting krona bullishness is offset by near-stagnant to negative growth in absolute terms and an ongoing fall in consumer prices, both of which validate the dovish Riksbank message. We believe that the Riksbank may cut sooner and faster than the ECB, the BoE, and the Fed, something that would be very welcome news to the heavily indebted household and property sectors, but not great for the currency over the short run.

Australian Dollar (AUD)

Our models continue to see medium-term risks tilted to the downside for the Australian dollar on weak terms of trade, underperformance of Australian equity markets, and the recent downside inflation surprises. While we’ve seen some improvement in one-year ahead consensus growth expectations, the more recent growth data has been disappointing.

However, it is important to note that the Australian dollar is cheap, relative to historical trends — suggesting many of these negative factors are priced into the currency. We also expect stabilization (but not a material recovery) in Chinese growth over coming quarters, though investors are currently reacting poorly to announcements of Chinese stimulus and likely have to see the positive impacts before it spills over to support the dollar.

In the long term, we are decidedly more positive on the Australian dollar versus the US dollar given the extreme undervaluation and Australia’s higher-than-average long-run potential growth.

New Zealand Dollar (NZD)

We are negative on the New Zealand dollar over the near term. Ongoing challenges to growth, choppy commodity prices, and the weak external balance — the current account is –6.9% of GDP — more than offset any benefit of high yields, especially after weak growth forecasts reduced future expected yields.

However, all is not bad. Markets priced in an extra 2024 rate cut from the central bank, but even with that, the New Zealand dollar is likely to remain among the highest yielding G10 currencies through 2024. China is likely to remain a drag in the short term, but early signs of stabilization in Chinese growth may provide some relief to the New Zealand export outlook.

In the long term, our New Zealand dollar outlook is mixed. Our estimates of long-run fair value suggest that it is cheap versus the US dollar and the Swiss franc and has ample room to appreciate, but is expensive against the yen and the Scandinavian currencies.