MARKET TONE
The US dollar (USD) remains very firm, gaining against most of its major currency peers as slow progress on inflation drove a significant repricing of market expectations for Federal Reserve (Fed) rate cuts this year. In early February, swaps reflected around 150bps of easing expected by the Fed this year. But market expectations have repriced significantly after higher-than-expected US inflation data in January, February and again in March. Fed officials appeared to be looking through the January and February data but the persistence in price pressures is getting harder to dismiss as a “bump in the road” on the way to price stability. Indeed, our own forecasts now anticipate 50bps of Fed rate cuts this year versus 100bps of cuts in our last forecast round. A high for longer Fed likely means a strong for longer USD. Factors driving exchange rates in the coming months are likely to revolve mainly around interest rate policy but also valuation and domestic politics.
Even a cursory glance at the overall performance of currencies so far this year shows that interest rates and interest rate expectations are shaping FX performance significantly. The Mexican peso (MXN) was a top performer overall in 2023 and has only recently lost ground to trade flat against the “king dollar” so far this year. The Banxico initiated its first rate cut of the cycle in March, but the benchmark rate remains elevated (11%) and (nominal and real) yields are still attractive for investors. The Chilean peso (CLP) is the weakest major currency in year-to-date terms, down more than 10%, as the Banco Central de Chile (BCCh) pursues its aggressive rate cut policy.
Meanwhile, the pound (GBP) is the best performing G10 currency so far this year outside the USD. Markets have been pricing in a shallower and slower round of rate cuts for the UK this year relative to most of the GBP’s peers, providing the pound with some support. At the foot of the year-to-date performance table sit the yen (JPY) and the Swiss franc (CHF). The Bank of Japan (BoJ) lifted its benchmark rate to zero, or a little above, from -0.1% in March. This was the BoJ’s first rate tightening in 17 years. At zero, however, yield spreads are still widely disadvantageous for the weak JPY. The Swiss National Bank (SNB) became the first G10 central bank to relax monetary policy when it cut its already low policy rate 25bps to 1.50% in March, driving CHF losses against other major currencies.
Our currency forecasts have been adjusted to reflect the outlook a further period of USD dominance this year as Fed policy remains tight relative to many of its major peers. Broadly, however, history does suggest the USD tends to soften once the Fed easing cycle gets underway and investors move out of the US currency to other, higher yielding assets. A mildly weaker USD may yet emerge later this year. Our forecasts anticipate some convergence in growth trends across the major economies moving into 2025 which may be more of a burden for the USD.
In addition to interest rate policy, valuation may become more of a factor for markets in the coming months. In broad terms, the USD looks relatively rich, or expensive, versus its major currency peers. In real effective terms, the USD has risen by around 30% in the past 10 years. This prompts us to think that longer run risks for the USD are tilted to the downside. In contrast, the JPY looks exceptionally weak in nominal and real effective terms. The JPY’s real effective exchange rate index reached a record low in Q1. The Japanese authorities are increasingly attentive to yen weakness, with USDJPY trading to new, multi-year highs (the highest since 1990). Comments from officials suggest a high state of alert among monetary officials. Intervention is a major risk if the JPY appears poised to weaken further.
The Canadian dollar (CAD) has lost significant ground in real effective terms in recent years and it also looks relatively cheap against the USD. Soft growth trends late last year and the domestic clamour for relief from tighter Bank of Canada (BoC) monetary policy have weighed on CAD sentiment. Interest rate spreads versus the US have widened, pinning the CAD back to the 1.38 area so where it may stay for now. Domestic growth trends have rebounded sharply in Q1 and the economy appears to be operating on a much stronger level than the BoC expected as recently as January. A sharp pickup in growth will leave policymakers in no rush to cut rates just yet. Our BoC rate call is unchanged (75bps of cuts this year, starting in Q3) but that does mean slightly more BoC easing now relative to the Fed this year versus slightly less in our previous outlook. That outlook is now more or less fully reflected in US/Canada spreads, meaning that while the CAD may not weaken that much more, it will not be able to regain much ground while rate differentials remain so averse.
The GBP remains cheap-looking in our opinion, with GBPUSD stuck on a 1.2- handle. The pound recovered well from the exceptional volatility and uncertainty that descended on UK markets and the political scene in 2022 but a more significant rebound has been limited by broader USD strength and slow UK growth. Growth trends are improving and sticky inflation may yet delay Bank of England (BoE) rate cuts until later this year which may provide the GBP with some support. The domestic political backdrop may add to short-term uncertainty in the pound, with a general election now looking likely in Q4. But the outcome could bolster its longer-term prospects. After fourteen years of Conservative party rule, polls suggest that Labour is heading for a landslide victory. A reset of the UK’s relationship with Europe could develop under Labour which would be modestly supportive of the GBP at least in the longer run, particularly against the EUR.
The UK election is not the only vote on the market’s radar. The Mexican presidential election will be held in June (polls point to a win for AMLO’s heir apparent Sheinbaum) and the political cycle is turning quickly in the US. Investors are likely to become more sensitive to polling trends in the presidential election as the race heats up after the summer. The prospect of another Trump term may lift expectations for a stronger USD—largely because candidate Trump has suggested broad tariffs on imports to the US could be part of his trade policy. Trade tensions could bolster risk aversion and add to demand for the USD. The CAD and MXN, with significant trade ties to the US, would be particularly sensitive to impediments to trade.
There are risks to the assumption of a stronger USD under a Trump presidency, however. Currency policy was somewhat muddled in the first Trump term. At one point, officials were apparently considering whether to intervene to curb USD strength (when the DXY was about 8% lower than it is right now). And there have been reports that Team Trump is considering a weak dollar policy to help rebalance global trade in a second Trump term. Foreign investors, especially those affected by tariff measures, might also be cautious about the potential fiscal/monetary policy mix in another Trump term and demand a higher premium for holding US assets, including the USD.
Shaun Osborne, Canada 416.945.4538
FX FORECASTS
CAD FX FORECASTS
NORTH AMERICA
MAJOR CURRENCIES
MAJOR CURRENCIES (continued...)
LATIN AMERICA
LATIN AMERICA (continued...)
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