The DXY dollar index traded as high as 114.50 on Monday, and at the time of writing was trading at 113.25, some 18% higher than the level seen at the start of the year. Over the weekend, UK chancellor Kwasi Kwarteng’s pledge to press ahead with the new government’s large tax cuts also contributed to dollar strength, with sterling hitting a new low of 1.035 against the dollar, before rebounding.
With markets repricing a higher federal funds terminal rate amid broad risk-off sentiment, we believe the dollar is set to be stronger for longer over the next six months. Instead of peaking at the year-end, we now expect the greenback to remain strong through the end of the first quarter next year and have extended our 0.96 EURUSD forecast to March 2023.
We recently upgraded the USD from neutral to most preferred in our FX strategy to reflect a stronger dollar on a broad basis:
The Fed is committed to lowering inflation even if leads to a potential recession in the US. Our reading of the FOMC communication is that the risk of a more prolonged rate hike cycle has increased, and the Fed has shown a higher acceptance of recession risks in the US if this is needed to bring inflation back to target. With the global growth outlook uncertain, the USD is likely to benefit both from its safe-haven quality and its yield advantage.
An escalating war in Ukraine could send energy prices higher, dragging down the euro. Russia has stepped up its military effort against Ukraine by announcing a “partial mobilization” of 300,000 reservists and threatening to use “all means” at its disposal to defend Russian territory. We believe this will likely have implications for energy prices and inflation, weighing down the economic outlook for Europe. As a result, we are keeping the euro as least preferred.
Concerns over UK debt sustainability look set to keep sterling under pressure. Sterling fell as much as 4.7% on Monday, after a 3.6% decline on Friday, as investors continued to react to a package of tax cuts and spending increases by the new government of Prime Minister Liz Truss. The yield on the 10-year UK government bond has also jumped to 4.13%, from 3.5% at the start of trading on Friday.
The reaction reflects concerns that the fiscal package puts Britain’s public finances on an unsustainable trajectory. We view this as a legitimate concern, and we don’t see enough measures in the package that look likely to boost economic growth over the medium term. As a result, we expect sterling weakness to persist, with a test of parity against the dollar possible. For the time being, we see sterling trading in a range between parity and 1.10 against the US dollar.
Near-term weakness expected for APAC currencies. A more hawkish Fed is likely to keep relative interest rate differentials in favor of the USD versus most APAC currencies. In addition, growth concerns in China, the Bank of Japan’s decision to keep monetary policy loose, and high energy prices are all adding downside pressure on North Asian currencies. We expect USDCNY to reach 7.2 and USDJPY to hit 145 in the coming months as the latest FX intervention is unsustainable, in our view.
Aside from positioning for near-term USD strength, we recommend making use of elevated FX volatility to engage in yield-enhancement strategies. We see opportunities to sell the downside risk in our preferred currencies in the APAC region, such as the AUD and SGD.
We have kept our most preferred position in the Swiss franc, as we believe the Swiss National Bank will remain hawkish after its 75bps rate hike last week. We see more upside for the CHF while European and US inflation stays high and believe the currency will profit from its safe-haven status as well as from the SNB’s rate hiking cycle.
Main contributors - Mark Haefele, Vincent Heaney, Daisy Tseng, Andrew Thompson
Content is a product of the Chief Investment Office (CIO).
Original report - US dollar set to be stronger for longer, 26 September 2022.
