USD Outlook, will it remain bullish?
Timing is nearly everything
Since late last year we have advocated that a weaker USD would be consistent with an improving global economic outlook. However, we have also said the USD had already declined meaningfully in 2020 and so this year’s weakness should be limited in scale and duration. The USD would slowly begin to recover versus most major currencies, including the RMB, later this year. There are two important reasons to explain this framework. First, the peaking of global growth, sequentially, would mark the end of the USD’s broad cyclical decline. Second, the Fed’s path towards policy normalisation should support the USD gradually, especially when tapering actually starts.
These points have underpinned our view of a gradual USD recovery, but the timing is wrong. Instead of these two forces slowly supporting the USD later this year and into 2022, this is happening earlier. As a result, we have pulled forward our timing for the USD to strengthen and expect this to continue through 2022 (see Table 1). We first pushed back against the idea that the hawkish Fed meeting in June is the specific catalyst. Fed funds futures had already discounted what the FOMC’s median dots suggested (i.e. +50bps come H2 2023, Chart 1). Plus, the decline in short-dated real Treasury yields since the June FOMC suggested the USD should be slightly weaker (Chart 2). However, an important part of our framework has been challenged, which relates to signs that global growth has peaked and is losing some momentum. If we expected the USD to temporarily weaken this year against a still recovering global economy, then the opposite should also hold true
When history rhymes
The USD’s weakness through 2020 looks comparable to 2017 when global growth was on a healthy upswing (Chart 3). This began to lose momentum towards the end of 2017, followed by global growth (excluding the US economy) slowing in 2018 and coincided with the USD bottoming. This has been an important template for us to consider this year and poses the question whether history would repeat?
Some nuanced thinking is required. Back then, there were a number of specific features that were USD supportive, in addition to the moderation of global growth. The Fed was in a clear tightening cycle, raising its policy rate by 100bps to 2.50% and real short-end US Treasury yields were relatively high (Chart 4). US-China trade tensions heightened materially with the imposition of tariffs, which also saw the RMB weaken by nearly 10% (Chart 5). This had negative spillover effects to other Asian currencies. Meanwhile, some EM currencies such as the ARS and TRY had also depreciated quickly given their vulnerabilities to pronounced imbalances. This led to contagion to other high yielding EM currencies. Put together, these developments amplified the USD rally.
In our view, the USD outlook is not exactly comparable to 2018 in terms of magnitude. However, we are not dismissive of the risks either. After all, US-China trade tensions have not really improved much and some EM currencies remain in a fragile position that could cause renewed contagion risks. Yet, one of our main arguments for the USD to strengthen gradually has centred on global growth peaking followed by the likelihood of losing some momentum. This is because the USD is an anti-cyclical currency
We have previously discussed how the global growth cycle and currency performance has a connection, in particular what it means for the USD. It is straightforward but those currencies that are more sensitive to rising commodity prices and can be riskier in nature should do better when global growth is accelerating (Chart 6). The opposite is also true. Indeed, the USD’s decline since April 2020 is consistent with the former. Yet, there are other valid arguments put forward to explain the USD’s anti-cyclical properties. For example, the BIS believes the broad USD is a ‘barometer’ of global liquidity. In a recent study, the authors state:
Although there is a general pecking order of how FX and growth interact over time, there is also a relationship with the USD tracking the global trade cycle for goods (Chart 7). There was a sharp increase in the pace of goods’ trade volumes last year but this has lost momentum lately (Chart 8). In our view, this is a function of the service sector re-opening in many countries and the well-known supply bottlenecks to produce goods. Slower global trade in goods would be consistent with the USD’s decline losing speed, if not reversing.
The Fed still matters
The global growth cycle is an important part of our USD framework but we do not rely on that alone. The Fed’s plan to taper and its divergent monetary policy stance from other central banks should eventually guide the USD stronger, especially once tapering actually starts. As we have shown previously, the degree of balance sheet expansion has helped to define relative currency performance since March last year (Chart 9). The smaller balance sheet expansions by the likes of the Norges Bank, RBA and Riksbank, for example, have been a critical feature to justify our long-standing preference for these respective currencies. While ‘taper talk’ has been a consistent part of Fed dialogue this year, the USD is an outlier on this basis, which implies the start of tapering could still impact the currency positively.
The key aspect of the Fed’s growing proximity to the actual taper is that it increasingly changes the framework through which the USD is viewed. Instead of interpreting better US data as a “risk on” event that weakens the safe-haven or countercyclical USD, the market increasingly sees the economic releases in the context of what it means for the timing and pace of Fed tapering. The USD bullish response to the stronger than expected July employment report is a recent example of this shifting personality and had been a missing feature for us to think more positively about the currency
This reaction function, the very opposite of RORO for the USD, has been growing in prominence over the last month. This is illustrated in Chart 10 of our DRIVERS measure. The declining line indicates that the USD is responding more frequently in the same direction as the economic surprise. RORO’s influence is loosening, allowing the USD to capitalise on the US recovery, and the associated normalisation of Fed policy.
An important corollary to this declining grip of risk appetite on FX is a rising prominence of yield differentials as a driver. On that metric, the USD actually stacks up reasonably well in the G10 context (Chart 11). Clearly, it offers higher carry over the EUR, but it also enjoys a yield premium over many others, even if the margin is thin in some cases. But in an environment of low volatility, being paid even a small amount of carry to hold the world’s pre-eminent low-risk currency will likely provide another bit of support to the USD. With the Fed being careful not to provoke the market with its moves to the exit, low volatility strikes us as a valid assumption.
What if we are wrong regarding volatility and risk aversion were to return afresh as the dominant driver? Then while the NZD and NOK may offer more generous yield terms, these currencies would be among the most sensitive to the downside in G10 FX, were the global mood to turn sour. Chart 12 shows the sensitivity of G10 currencies to changes in the S&P500 over the last five years. Such an outcome is not our base case, but this scenario would quickly transform our forecast of a grind stronger in the USD to one of potentially disruptive strength. Our forecast of USD strength captures some of that probability, however small, that something more onerous could transpire.
The reality is that our forecasts predominantly and justifiably reflect a lack of drama and instead a sequence of trade-offs. Perhaps we should look for more emotion in our outlook, but the global story at this juncture does not lend itself to any credible drama. We expect the USD to strengthen, but modestly so. It should capitalise on less cyclical selling pressure as the global economic recovery matures, and on the Fed’s move to the exit and reassuring yield levels.
Yet, with the possible exception of a fragile-looking EUR, the other currencies in G10 FX also have merits that argue against forecasts of a more precipitous decline. Global growth may slow but should remain healthy by historical standards, and does not point to a scramble out of commodity-sensitive FX, for example. Some, in EM and DM alike, should see high yields act as a parachute on any descent. Instead, beyond the USD, the interest should centre on the relative stories – a NZD outpacing the AUD, or GBP outshining the EUR.
There are of course risks, which, were they to crystallise, would inject a lot more urgency into our view of relatively benign USD strength. Among the candidates would be a renewed surge in risk aversion prompted by a particularly resistant COVID-19 variant, or a more rapid tightening by the Fed should inflation prove less transitory in the US than expected. We will be mindful of these and other risks, but the central story is one of transition. We believed that this shift to USD strength would begin to happen later in the year we have updated our timing.
A quick word on EM FX
Many EM currencies have struggled to stay afloat with strong currents moving against them lately. The Fed’s hawkish stance may have started the recent bout of EM FX weakness but it has become more complicated recently amid concerns about global growth. In particular, China’s sequential (q-o-q) growth recovery appears to have peaked in 2Q, and that has historically been a good leading indicator for the rest of the world.
As discussed, some moderation in global growth would likely be USD supportive and hence make it harder for EM FX to outperform. Moreover, it would only emphasise the importance of domestic policy frameworks in differentiating which EM currencies should outperform the others. Given intra-EM policy divergence should become a more powerful force, the likes of the BRL, MXN, CLP, RUB, HUF, and the CZK should have an advantage versus the rate hike laggards. It is clear that some currencies (ASEAN-4) are in a slower lane given the sluggish growth outlook and likelihood of loose monetary policy settings amid continued challenges from COVID-19.
However, the most important divergence is between the Fed and PBoC. The former is transitioning towards tapering, while the PBoC aims to support growth via a lower RRR. This supports our thinking that USD-CNY should move higher in the coming months. This should happen slowly, which in turn EM FX can adjust to in an orderly manner. Nonetheless, it is another reminder that the USD’s outlook will not be as benign as it used to be.
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