The US dollar’s best days may be behind us
This year’s rally was led primarily by an increasingly hawkish Fed as inflation hit a 40-year high. A flight to safety on global growth concerns over Europe and China also supported the dollar.
But we think the USD rally has run its course, and we see limited upside potential from here.
Fed rate hike expectations are fully priced in. Markets are anticipating US rates moving into restrictive territory, but there are early signs that core inflation rates are moderating. The Fed’s favorite inflation indicator, the Personal Consumption Expenditure (PCE) index, rose just 0.2% month-over-month in April. It was the smallest gain since November 2020 and followed a 0.9% jump in March. The core PCE measure, which excludes volatile food and energy prices, is now up 0.3% over the past three months. The year-on-year increase in the base measure, 4.9%, was the smallest since December.
Meanwhile, U.S. 10-year breakeven inflation rates fell to 2.6% from 3.0% a month ago, indicating heightened confidence in the Fed’s ability to rein in inflation. This heightened confidence that inflation is past its peak has prompted markets to lower their expectations for Fed tightening this year. Fed funds futures now imply about 262 basis points (bps) of rate hikes for 2022, down from a peak of around 285 bps earlier in May.
Other central banks are starting to catch up on the tightening path. The European Central Bank has become less dovish, with President Christine Lagarde signaling the likelihood of at least 50 basis points of hikes by the end of September. Higher-than-expected eurozone inflation readings for May of 8.1% – the highest on record by the currency bloc – added to the hawkish mood. This will give the Swiss National Bank (SNB) more leeway to tighten. Historically, the SNB has had a clear commitment to stem inflation through currency appreciation. It was also the last message from SNB Chairman Thomas Jordan ahead of the upcoming tightening change.
The USD rally exceeded our expectations. Although we have been guiding near-term dollar strength since the start of the year due to the Fed’s tightening cycle, the magnitude of the appreciation exceeded our expectations as the Fed became increasingly hawkish. In addition, growth issues in China and Europe, following the outbreaks of COVID-19 and the war in Ukraine, respectively, also boosted safe-haven flows into the greenback.
We now see the risks to the greenback as more balanced, especially against the Swiss franc and the Japanese yen, which are also traditional safe-haven currencies. Any escalation in geopolitical concerns should support these two low yielding currencies.
In addition, we expect a further 10% rise in broad commodity indices over the next six months, supported by structural imbalance, prohibitions in various forms (sanctions, export restrictions) and weather risks. This bodes well for commodity currencies against the USD.
Thus, we recently lowered our USD preference to neutral. We expect any further USD gains to be modest and short-lived. We are no longer negative on the Swiss franc, with a more balanced outlook due to the SNB’s renewed focus on inflation. That said, despite the ECB’s plans to initiate rate hikes, we expect limited gains for the Euro due to economic headwinds. Instead, we favor commodity-linked currencies including the Australian dollar, New Zealand dollar, Norwegian krone and Canadian dollar, which should benefit from stronger investment activity and improving of the balance of payments.
Main contributors – Mark Haefele, Thomas Flury, Patricia Lui, Vincent Heaney, Jon Gordon
The content is a product of the Chief Investment Office (CIO).
Read Original Daily – The US Dollar’s best days may be behind us, May 31, 2022.