investment insights
Is the USD bear market resuming?
Key highlights
- Following a strong March, the dollar has weakened so far in April, as too much optimism was in the price and US yields stabilised. We maintain a view of modest depreciation, although May has historically been a strong seasonal month for the greenback
- Euro-dollar has likely troughed; although there will be periods of short-term weakness (e.g. in May), we maintain a medium-term constructive view
- Dollar-yen has declined in April; we expect it to gravitate lower in the months ahead
- The Swiss franc has recovered after a steep depreciation since the beginning of the year. We continue to expect euro/Swiss franc to range trade between 1.10 and 1.12
- Sterling has come under a reality check, with positive cyclical factors in the price but structural headwinds only recently being priced in. A weak dollar should continue to lend support, but any rallies should be capped around the 1.40 level
- Despite a decline in euro-dollar and a sharp rise in US 10Y yields in Q1, emerging market (EM) currencies have held up quite well. We believe this reflects wider EM-US GDP differentials over H1. However, the spread should narrow from Q3, creating a more challenging backdrop for emerging currencies
- We reiterate our year-ahead theme of rotation to select emerging currencies.
Following a strong March, the trade-weighted (TW) dollar index has depreciated so far in April. The main reasons are the stabilisation of US nominal and real yields and negative USD seasonality in April. We maintain the view that the dollar is likely to depreciate further on a multi-month basis, based on the sharp global recovery (which is likely to become more synchronised as the vaccine roll-out in Europe progresses) and on the dollar’s overvaluation, which has widened recently. We believe that the impact from the US fiscal stimulus is now largely in the price and, absent any big surprises, it is unlikely to influence the FX market further.
That said, 2021 has proven to be a year of differentiation and of reversal in trends. Furthermore, we would caution that May has historically been a very strong USD month, so it is also reasonable to expect a dollar rebound.
The main risk to our bearish USD view is clearly another abrupt yield increase without the Federal Reserve (Fed) pushing back against it. This would put pressure on risk appetite and underpin the dollar. While this is a non-negligible risk, we find it hard to believe that the Fed would remain idle in the face of a disorderly and persistent tightening of financial conditions, especially under its new framework of average inflation targeting.
Regarding EURUSD, we maintain our forecasts unchanged. A key metric to watch is the progress of the EU vaccination programme. We expect a substantial pick-up in the months ahead as vaccine supply increases, but any new bottlenecks would represent a headwind for the currency. EURCHF is likely to reflect better risk appetite, although eurozone-Swiss real rate spreads do not suggest extensive upside. We think the pair will trade in a range of 1.10-1.12.
Turning to sterling, we believe the depreciation since late-February is simply a reality check. Positive cyclical factors are now in the price, but structural headwinds (Brexit-related) are only just being priced in. We expect the weak dollar to lend support, but rallies will be capped around the 1.40 level, unless the Bank of England surprises with an earlier-than-anticipated rate hike.
On the USDJPY, following its break above 110, the pair has declined recently to below 109. We expect further gradual declines due to valuation, Japan’s solid trade surplus, and ongoing equity outflows from Japanese investors.
In the Nordics, we reiterate our preference for the NOK and expect further NOKSEK upside. In the core commodity FX bloc, we think current AUD levels are attractive to position for upside; CAD should remain supported by global and domestic developments, whereas the NZD is likely to lag.
Over the first quarter, the GBIEM benchmark EMFX-USD index declined 3.9% compared to a 4.7% decline in EURUSD, suggesting EM currencies had held up quite well considering the very large 85-bps rise in US 10Y yields. We believe this partly reflects higher EM-US growth differentials of near five percentage points over H1, vs a decade average of two percentage points. That said, growth differentials are expected to compress in H2, suggesting that EMFX will face depreciation pressures going forward.
This view continues to favour our “rotation to select EMFX” theme, with CNY remaining our top pick. Strong balance-of-payments support, attractive yield, as well as likely USD selling flows by onshore market participants should allow the CNY to hold up well against the USD, EUR, and CHF.
Main risks to our views: The main upside risk to our forecasts comes from a stronger recovery in global trade, which would send the USD into an even steeper decline and support bigger and broader rallies in the G10 and emerging markets. On the downside, we see the following risks: First, further rapid increases in US yields. Second, the Fed turning less dovish and so triggering a market reaction like 2013's "taper tantrum". Third, further delays in the distribution of Covid-19 vaccines that would increase the risk of prolonged restrictions and economic disruption. Fourth, a premature withdrawal of fiscal support.
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