Dollar caught between global and US reflation

investment insights

Dollar caught between global and US reflation

Vasileios Gkionakis, PhD - Global Head of FX Strategy

Vasileios Gkionakis, PhD

Global Head of FX Strategy
Kiran Kowshik - FX Strategy

Kiran Kowshik

FX Strategy
Homin Lee - Macro Strategist - Asia

Homin Lee

Macro Strategist - Asia
Sophie Chardon - Cross-Asset Strategist

Sophie Chardon

Cross-Asset Strategist

Key highlights

  • Dollar strength returned in March, reflecting rapidly rising US yields. We think this is temporary and reiterate our view of moderate dollar weakness within an environment of solid growth recovery and gradually higher global yields
  • Euro-dollar should continue to benefit from the global trade recovery, but the rise in US yields and the dovish European Central Bank’s spin imply that appreciation may be less pronounced than we had expected initially
  • We have revised our dollar-yen trajectory somewhat higher, but maintain our bias for yen appreciation
  • The Swiss franc should lag the euro, and we see euro-Swiss franc trading within the 1.10-1.12 range
  • Sterling should be underpinned by the weaker dollar and vaccination success, but structural Brexit headwinds will cap gains
  • Upward growth surprises in emerging markets and well-supported energy prices suggest the GBI EMFX index should hold up well in the first half of the year, but narrower growth differentials with the US and elevated debt loads should result in a more cautious second-half 2021 outlook
  • We reiterate our year-ahead theme of rotation to select emerging market currencies (renminbi, Korean won, Taiwan dollar, Czech koruna, and Israeli shekel), but are more cautious on LatAm FX. This month, we downgrade the Brazilian real and Turkish lira and upgrade the South African rand.

Dollar strength returned in March, as US long-dated nominal and real yields rose appreciably. This abrupt increase alongside higher rate volatility led investors to unwind further dollar shorts, pushing the greenback higher. However, the dovish outcome of the mid-March FOMC meeting started weighing on the dollar again.

Historically, trade and growth upswings bring rising yields and a weaker dollar

Aside from near-term fluctuations, our core view remains unchanged: the global economy is currently at a relatively early stage of a strong recovery. Historically, such trade and growth upswings bring gradually rising yields (reflecting expectations of better growth prospects) and a weaker dollar.

We think this is likely to be the case again. The main risk to this view is clearly another abrupt yield increase without the 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.

All that said, the recent swift increase in US yields suggests that some of our forecasts are in need of fine-tuning.

Specifically, we reduce our EURUSD forecast to 1.23 from 1.27 for Q2 2021, and closely monitor developments in the European vaccination rollout programme given the recent bottlenecks. The euro-Swiss franc currency pair is likely to reflect better risk appetite, although eurozone-Swiss real rate spreads do not suggest substantial upside. We think the pair will trade in a range of 1.10-1.12.

Sterling gains cannot be sustained far beyond 1.40 given the structural Brexit headwinds

Turning to sterling, the recent setback supports our view. A weaker dollar and the vaccination success will underpin the currency, but gains cannot be sustained far beyond the 1.40 level given the structural Brexit headwinds. As for the Japanese yen, we trim our forecasts further to 104 by Q2 2021, largely due to the rise in US yields. However, we maintain a downside bias due to valuation, ongoing selling of equities and bonds by Japanese investors, and the significant improvement in Japan’s trade balance.

In the Nordics, we reiterate our preference for the Norwegian krone and expect further NOKSEK upside. In the core commodity FX bloc, we expect moderate gains for the Australian dollar and Canadian dollar, but think that the New Zealand dollar will lag.

Solid expectations for emerging market Q1 growth and stronger energy prices suggest emerging market (EM) currencies can still hold up well for Q1 and part of Q2. However, two related risks are lurking that could cap the rally: a sharp rise in US real yields, and markets acting in anticipation of a re-narrowing of EM-US growth differentials in the second half of the year (as US growth faces upside revision risk on more fiscal stimulus).

All told, we prefer to stick with our “rotation to select EM FX” theme, the renminbi being our top pick, followed by the Korean won, Israeli shekel, Czech koruna, and Chilean peso.

The main upside risk to our forecasts comes from a stronger recovery in global trade, which will 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 Federal Reserve turning less dovish and so triggering a market reaction like 2013’s “taper tantrum”. Third, a delay in the distribution of Covid-19 vaccines that would increase the risk of new restrictions and economic disruption. Fourth, a premature withdrawal of fiscal support.

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