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Favor USD and JPY as Risks Mount

Higher-for-longer US interest rates and the ongoing monetary policy tightening across the G10 promise additional economic weakness ahead. This is likely to hold the US dollar at current high levels and eventually lead to a strong rally in the yen relative to cyclical, commodity-sensitive currencies.

Senior Portfolio Manager

Strong US economic data, moderating risks of a banking/credit crisis, and a negotiated proposal to avert a debt ceiling shock pushed US yields and the US dollar higher during May. The Canadian dollar followed the US dollar higher on resilient economic data and the potential positive spillover from the improved near-term US growth outlook. Higher expected yields also supported the British pound, in response to a positive surprise in UK inflation, and the Australian dollar, as the Reserve Bank of Australia (RBA) stepped forth from the sidelines with another 0.25% increase in rates.

A main currency market driver for the month may have been the better near-term economic outlook and expectations of higher-for-longer monetary policy rates, but risks of a recession into next year remain. In fact, the persistence of inflation and the need for further monetary tightening likely increase negative tail risks into 2024. As a result, the US dollar should remain on the strong side for now. Global recession risks and the high likelihood that central banks might ease in response are positive for the yen but negative for pro-cyclical currencies such as the Australian dollar, the Canadian dollar, and the Norwegian krone. The euro is likely to remain in a range, while the British pound is at risk of falling back into stagflationary quicksand should the Bank of England have to tighten policy significantly in a slowing economy in order to finally gain control of inflation.

Figure 2: May 2023 Directional Outlook

May 2023 Directional Outlook

Note: All individual currency views in the table above are relative to the G-10 average. Source: State Street Global Advisors, as of 31 May 2023.

US Dollar (USD)
The US dollar is expensive and is likely to fall at least 10%–15% over the coming years but it is too soon for a downtrend now. In the near term, the resilience of the US economy and the stickiness of inflation should support short-end US yields and the US dollar in the near term. In the medium term, safe-haven demand may further support the US dollar as the cumulative impact of monetary tightening threatens growth and additional volatility across risky assets. A more sustainable dollar weakness would likely have to wait until the investors can see through the fog of tight monetary policy and recession risk.

Canadian Dollar (CAD)
Our models are negative on the Canadian dollar on weaker commodity price trends, poor relative local equity market performance, and the drag from high household debt. However, tight labor markets, a resilient consumer, and an improved growth impulse from the US mitigate that negative view. The Canadian dollar’s high correlation to the US dollar also makes it attractive vs. cyclical currencies such as the Norwegian krone and the Australian dollar given the possibility of a global slowdown. In the longer term, the Canadian dollar looks cheap relative to the euro, the franc, and the US dollar, and its long-term potential growth is poised to improve on factors such as strong immigration.

Euro (EUR)
Our models see downside risks for the euro vs. the US dollar on higher US yields and better growth vs. recent deceleration in European Union economic data. We are more positive vs. the broader G10. This is largely the result of weakness across more cyclically sensitive G10 currencies rather than an outright euro-positive story. Currencies such as the Australian dollar, the Norwegian krone, the New Zealand dollar and, to some extent, the Canadian dollar are more exposed than the euro to a global economic slowdown, weak commodity prices, and the disappointing China recovery.

British Pound (GBP)
The British pound is currently holding strong as investors expect another 100 bp of monetary tightening after the April core Consumer Price Index (CPI) set a fresh cycle high and economic data beat gloomy expectations. But we see major risks ahead. Rapid wage increases risk imbedding high inflation, requiring the Bank of England to take aggressive action—action that would likely cause recession. Not doing so risks loss of monetary policy credibility—both are bad for the pound.

Japanese Yen (JPY)
We saw risks for a weaker yen last month on rising US yields and calming fears of a banking crisis. That happened and now our outlook is slightly positive. While it may take some time, we believe the next big move in global yields is lower alongside weaker growth. This is a yen-positive scenario. The Bank of Japan is patiently studying the Yield Curve Control (YCC) policy, but the ongoing inflation and rising wages suggest further relaxation of the policy by end-Q3, another positive for the deeply undervalued yen.

Swiss Franc (CHF)
The franc is extremely expensive in our long-run fair value estimates and remains overbought in the short term. Its recent strength does not make fundamental sense as inflation is beginning to roll over, while growth is clearly decelerating, and Swiss yields are falling relative to the G10. We see downside risks to the franc, though we are patient as the Swiss National Bank has strong incentive to continue to intervene to limit weakness, until it sees inflation decline more substantially.

Norwegian Krone (NOK)
We remain negative on the Norwegian krone in the near term on weak/volatile oil prices, tepid economic growth, the ongoing central bank selling of the krone, and the poor local equity market performance. That said, the krone has already fallen dramatically. Any pick-up in oil prices, a hawkish surprise from the Norges Bank, or other positive catalysts would likely trigger a material, though likely temporary, rally.

In the longer term, the krone is historically cheap relative to our estimates of fair value and is supported by steady potential growth. Thus, we expect strong gains eventually, but reiterate that the krone faces a tough near-term environment.

Swedish Krona (SEK)
Swedish recession risk looms large and the recent currency weakness should create upward pressure on inflation and the central bank to further tighten policy. However, high household debt levels and commercial real estate financing risks make aggressive monetary tightening difficult. The puts the central bank and the currency in a tough predicament.

In the long term, the outlook is much more positive. The krona remains among the cheapest currencies in the G10 in our fair value estimates. Eventually Swedish and global inflation will be under control and the Swedish and regional economies will begin a more durable recovery. Once that happens, the krona has substantial room to appreciate on a sustained basis.

Australian Dollar (AUD)
Weak/choppy commodity prices, the disappointing China recovery, slowing consumer activity, negative real wage growth, and our expectation of rising equity market risk in H2 are meaningful headwinds for the Australian dollar. The Reserve Bank of Australia raised rates in May and moved back to a tightening bias, which should help, but not by enough to eliminate additional downside risk.

In the longer term, the Australian dollar outlook is mixed. It is cheap vs. the US dollar and the franc, and has room to appreciate, but is expensive against the pound, the yen, and the Scandinavian currencies.

New Zealand Dollar (NZD)
We are negative on the New Zealand dollar in the near term. Rising recession risk, weak commodity prices, and the record-low current account more than offset any benefit of high yields. And the Reserve Bank of New Zealand’s dovish shift toward a pause further reduces that yield support for the currency. In the longer term, our New Zealand dollar outlook is mixed. Our estimates of long-run fair value suggest that it is cheap vs. the US dollar and the Swiss franc and has room to appreciate, but is fairly valued vs. the Canadian dollar and the euro, and is expensive against the Australian dollar, the British pound, the yen, and the Scandinavian currencies.

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