The Potential Turning Point for the US Dollar
The long-anticipated shift in the US dollar’s trajectory might finally be happening. The current mix of tight monetary policy and loose fiscal policy is ending. For the past three months, inflation pressures have moderated, boosting the confidence of Federal Reserve officials that inflation is heading back towards its 2% target. At the July FOMC meeting, Federal Reserve Chair Powell strongly hinted at a potential rate cut in the next meeting. This expectation might be further reinforced at the Jackson Hole symposium in late August. The recent jump in the US unemployment rate, following a series of disappointing labor market data, has increased expectations for a 50 basis points cut to kick off the easing cycle.
Easing Monetary Policy Across High-Income Countries
Except for Japan, high-income countries are set to accelerate their easing of monetary policies in the coming months. This easing trend is expected to continue not just next year but into 2026. The key to the dollar’s exchange rate will likely depend more on US monetary policy than on other central banks cutting rates.
The Dollar’s Recent History and Market Expectations
In Q4 2023, the dollar fell sharply as markets anticipated aggressive Fed rate cuts, only to rebound in Q1 2024 when these expectations were unwound. By December 2023, the Federal Reserve’s median forecast included three rate cuts in 2024, but markets quickly priced in more than six cuts by mid-January 2024. This dramatic fluctuation, driven by shifts in Fed policy, is expected to continue impacting the dollar.
Political and Economic Factors
Two significant factors are influencing the dollar. Firstly, the US presidential election dynamics have changed, especially with President Biden withdrawing his reelection bid. Many now see a second term for Trump as likely, given his stance on the strong dollar’s impact on American competitiveness. Trump’s administration views other countries as keeping their currencies weak to gain export advantages, which resonates with many Americans.
Secondly, the US labor market’s deterioration has triggered Sahm’s Rule, indicating a recession when the three-month average unemployment rate rises 0.5% above the past 12-month low. With the US economy no longer overheating, the Federal Reserve is expected to ease policy more aggressively than previously indicated in the June Summary of Economic Projections.
The Dollar’s Role and Global Financial System
The dollar’s role as the global numeraire was a deliberate choice by American officials and banks post-WWII, codified by Bretton Woods. Even after the US decoupled the dollar from gold 53 years ago, it maintained this role through the era of floating exchange rates. The dollar’s role has been crucial for US power projection, particularly since 9/11, with the weaponization of the dollar allowing the US to check terrorist financing and sanction adversaries. However, concerns have arisen, highlighted by Treasury Secretary Yellen, that extensive sanctions are encouraging alternative payment systems that bypass the US dollar.
Potential Impact of Trump’s Policies
A second Trump term’s mercantilist policies, favoring a weaker dollar, could further drive its decline. According to the OECD’s purchasing power parity measure, the dollar was more overvalued against the yen and euro recently than on the eve of the Plaza Agreement in 1985, which saw coordinated intervention to drive the dollar lower.
Distinguishing Cyclical Decline from De-dollarization
It’s important to distinguish between a cyclical decline in the dollar and de-dollarization. The dollar’s role isn’t solely tied to its use in invoicing and settling trade. Recent internet rumors about a supposed 50-year-old US-Saudi agreement to price oil in dollars are unfounded. Even if some OPEC members accepted other currencies, it wouldn’t challenge the dollar’s dominance. Countries like Saudi Arabia and the UAE peg their currencies to the dollar, effectively outsourcing their monetary policy to the Federal Reserve. Thus, when the Fed cuts rates, these countries will follow suit.
Historical Context and Eurodollar Market
The origins of the dollar-centric financial system and its resilience post-Bretton Woods may lie in historical events like the 1956 Suez Crisis. The US leveraged its financial power over the UK, which, combined with the interests of US and British banks, led to the development of the Eurodollar market. This market has grown significantly, with non-US banks holding about $50 trillion in dollar debt. When the dollar rises, the cost of servicing this debt increases, creating a self-reinforcing cycle. Conversely, as US interest rates decline and the dollar weakens, low-cost borrowing attracts foreign entities, repeating the cycle.
Emerging Markets Performance
Emerging market currencies were mixed in July, with the MSCI Emerging Market Currency Index posting a slight increase while the JP Morgan Emerging Market Currency Index declined. The Mexican peso faced pressure due to uncertainty following the early June national election and the potential impact of a second Trump term. Emerging market bonds also underperformed, with the premium of JP Morgan’s Emerging Market Bond Index over Treasuries widening.
In summary, the anticipated shift in US monetary policy and the evolving political landscape are likely to weigh on the dollar. However, this cyclical decline should not be confused with de-dollarization, as the dollar’s role in the global financial system remains deeply entrenched.
Currency Performance in July
Best Performers
- Japanese Yen (5.3% weight in index):
- Performance: Best performer with a 7.25% rise.
- Contributing Factors: Benefited from intervention, a short-squeeze, and anticipation of a more hawkish Bank of Japan stance, which materialized at the end of July.
- Sterling (4% weight in index):
- Performance: Rose by 1.7% in July.
- Chinese Yuan (0.55% weight in index):
- Performance: The strongest developing country currency.
- Index Weighting: Nearly 23%, second only to the US dollar.
Weakest Performers
- Mexican Peso:
- Performance: Declined by 1.6%.
- Contributing Factors: Unwinding of carry trades and post-election uncertainties.
- Australian Dollar:
- Performance: Fell by 1.9%.
- Contributing Factors: Various forces, including the unwinding of short yen carry trades, contributed to its decline.
United States
Federal Reserve’s Position and Market Expectations
The Federal Reserve has aligned with market expectations, indicating that the rate-cutting cycle is likely to begin in September. The moderation of price pressures has provided the central bank with the flexibility to ease monetary policy, aiming to sustain the soft landing of the economy. Derivatives markets have already priced in one rate cut fully and suggest a 70% chance of a third cut this year.
Economic Growth and Quality Concerns
The US economy expanded at an annualized rate of 2.8% in Q2, up from 1.4% in Q1. This growth was driven by stronger consumption, increased government spending, and private investment, including a rise in inventories. However, the quality of this growth is questionable, and many economists predict a reversion to the slower pace observed in Q1 for the second half of the year.
Impact on the Dollar
The US dollar has been supported by the favorable policy mix of tight monetary policy and loose fiscal policy. However, with the Federal Reserve poised to begin its monetary easing cycle, this policy mix will be less supportive of the greenback. The Dollar Index, which fell in the first half of July, saw a recovery in the latter half. While there may be some additional room for upside correction, the peak of the dollar’s strength in the current extended cycle is likely behind us.
Key Takeaways
- Rate Cuts Expected: The Fed is expected to start cutting rates in September, with markets pricing in multiple cuts by year-end.
- Economic Growth: Q2 saw stronger growth, but its quality is in question, with a potential slowdown anticipated in the second half of the year.
- Dollar Outlook: The shift in monetary policy will likely reduce support for the dollar, suggesting that its strongest period may have passed.
This combination of moderating price pressures and the Fed’s anticipated rate cuts indicates a shift in the economic landscape that will likely impact currency markets and broader financial conditions in the coming months.
Eurozone
European Central Bank (ECB) and Market Expectations
The European Central Bank initiated its first rate cut in June, and the market anticipates another cut in September, followed by an additional cut in Q4. The swaps market has almost a 25 basis point cut priced in for each quarter through mid-next year. The European economy showed minimal forward momentum, growing by only 0.3% in Q2.
Political Landscape and Inflation
European political tensions have eased with the European Commission firmly in place. France is under a caretaker government, but there are expectations that President Macron might appoint a new prime minister in August. Hungary’s rotating EU presidency and the Prime Minister’s recent trip to Russia have caused some concern. Additionally, three German states (Saxony, Brandenburg, and Thuringia) are holding elections next month.
Eurozone inflation rose at an annualized pace of 4.0% in Q2, matching the pace of Q1. In H2 2023, inflation rose by less than 1% at an annualized rate, suggesting challenging base effect comparisons in the coming months. However, the euro’s exchange rate may be more influenced by the expected aggressive easing from the Federal Reserve over the next several quarters.
Exchange Rate Sensitivity and US-German Rate Differential
The two-year US premium over Germany, which often correlates with the exchange rate, has been trending lower since mid-April. This spread recorded a new low for the year, near 152 basis points, following the US jobs data on August 2. The euro peaked in mid-July near $1.0950, its highest level in four months, and found support on August 1 near $1.0775. We expect this support level to hold in the coming weeks. The high for the year, which might be challenged, was set in early March near $1.0980.
Key Takeaways
- ECB Rate Cuts: The ECB is expected to continue cutting rates, with the market pricing in a 25 basis point cut each quarter through mid-next year.
- Economic Growth: The Eurozone economy grew by 0.3% in Q2, indicating limited forward momentum.
- Political Dynamics: Political tensions have eased, but upcoming elections and leadership changes could impact the economic landscape.
- Inflation and Exchange Rate: Eurozone inflation remains high, but the euro’s exchange rate is likely to be more sensitive to the Fed’s anticipated aggressive easing. The US-German rate differential has been decreasing, which may support the euro in the near term.
The evolving monetary policies and political developments in Europe and the US will continue to shape the financial landscape and influence currency markets in the coming months.
United Kingdom
Bank of England’s Rate Cut and Market Expectations
In a closely contested 5-4 vote, with Governor Bailey casting the deciding vote, the Bank of England (BoE) initiated its first rate cut of the cycle on August 1. The BoE provided limited forward guidance, stating that future decisions would be made on a meeting-by-meeting basis. Despite this, the swaps market remains confident, fully pricing in another rate cut for the November BoE meeting and nearly convinced of a third cut by the end of the year.
Inflation Outlook and Economic Projections
The best inflation news is likely behind the UK for several months. The BoE acknowledges this, with its median forecast predicting inflation to be at 2.3% in Q3 and 2.7% in Q4, up from 2.0% in June. In Q3 2023, the UK’s Consumer Price Index (CPI) rose at an annualized rate of 1.6% and less than 1% in Q4 2023. Matching these figures this year will be challenging.
Fiscal Policy and Economic Indicators
The new UK government appears committed to fiscal consolidation. The Office for Budget Responsibility projects that the deficit in the new fiscal year may fall below 3% for the first time since 2019. This fiscal discipline is expected to support economic stability and investor confidence.
Sterling’s Performance and Technical Analysis
Since July 17, when sterling set the high for the year near $1.3045, it has pulled back, which appears corrective in nature. This correction may have completed near $1.27. A move above $1.29 could signal a retest of the 2023 high near $1.3140.
Key Takeaways
- BoE Rate Cuts: The Bank of England has begun its rate-cutting cycle, with the market expecting additional cuts in November and possibly by year-end.
- Inflation Forecast: Inflation is expected to rise slightly, with the BoE forecasting 2.3% in Q3 and 2.7% in Q4, making it difficult to replicate last year’s lower rates.
- Fiscal Consolidation: The new government is focused on reducing the deficit, which may fall below 3% of GDP for the first time since 2019.
- Sterling Outlook: The recent pullback in sterling appears corrective, and a move above $1.29 could indicate a retest of the year’s high near $1.3140.
These developments highlight the delicate balance the Bank of England must maintain between supporting economic growth and controlling inflation, while fiscal policies aim to reinforce economic stability.
China
Yuan’s Performance and Economic Measures in H1 2024
The Chinese yuan experienced a consistent decline every month in the first half of 2024 before rising by about 0.55% in July. This increase occurred despite a surprise rate cut by the People’s Bank of China (PBOC). The yuan’s earlier weakness had led many to delay rate speculation to later in Q3. However, the disappointing Q2 GDP growth of 4.7% year-over-year (down from 5.3% in Q1) and a soft June CPI of 0.2% year-over-year prompted the PBOC to cut rates.
Shifts in Monetary Policy
The PBOC is shifting its monetary policy tools, notably increasing the significance of the seven-day reverse repo rate, which was cut by 10 basis points to 1.7%. Banks responded quickly with similar cuts in prime rates. Additionally, the PBOC reduced the previous benchmark one-year Medium-Term Lending Facility Rate by 20 basis points to 2.30%. Despite these measures, more economic actions appear necessary for Beijing to achieve its growth target of 5%.
Broader Economic and Trade Dynamics
Efforts to curb Chinese export penetration are spreading from high-income countries to more nations in the Global South. The yuan’s recent strength seems more influenced by the unwinding of carry trades and broad dollar weakness, particularly against the yen, than by formal and informal measures by Chinese officials to manage the exchange rate. The dollar fell to nearly CNH7.14 following disappointing US employment data, marking its largest daily decline since March 2023.
Impact of US-China Financial Movements
The yuan’s exchange rate is largely driven by the overall direction of the dollar and the state of carry-trade strategies. US Treasury International Capital (TIC) data revealed that Chinese investors sold a record $42.6 billion of long-term US securities (including Treasuries, agency, and corporate bonds, and equities). In the first five months of 2024, Chinese investors divested nearly $80 billion in US securities.
Regulatory Measures in China
China has announced measures to discourage equity short sales and is considering significantly raising fees associated with high-frequency trading. These steps aim to stabilize financial markets and support the yuan.
Key Takeaways
- Yuan’s Performance: The yuan rose by about 0.55% in July after a continuous decline in the first half of 2024, driven by PBOC rate cuts in response to weak GDP growth and low inflation.
- Monetary Policy Shifts: The PBOC is emphasizing the seven-day reverse repo rate and has cut various benchmark rates to stimulate the economy, but further measures are likely needed to meet growth targets.
- Trade and Economic Dynamics: Efforts to limit Chinese exports are expanding globally, and the yuan’s strength is influenced by broad dollar movements and carry trades.
- US-China Financial Movements: Significant divestment by Chinese investors in US securities and new regulatory measures in China aim to support market stability.
These developments highlight the complex interplay between domestic economic policies and international financial dynamics, impacting the yuan’s performance and broader economic outlook.
Japan
Bank of Japan’s Decisive Actions and Market Reactions
The Bank of Japan (BOJ) has taken decisive steps to address economic conditions, hiking its overnight target rate by 15 basis points to 0.25%. This move signals the potential for further rate hikes, provided that price pressures remain firm as officials expect. The swaps market is currently discounting a 10 basis point increase by the end of the year.
Market Impact and BOJ’s Bond Purchases
The BOJ’s actions have significantly impacted Japanese equity markets. The Nikkei has declined by 13% over the past three weeks, and the Topix Bank Index has dropped more than 11% in the past two weeks, tempering more aggressive expectations for additional rate hikes. Additionally, the BOJ announced plans to reduce its bond purchases by about JPY400 billion per quarter through the end of the next fiscal year, essentially halving its purchases and putting them below the amount maturing. The BOJ’s balance sheet stands at about 128% of GDP, in stark contrast to the Federal Reserve’s 25% and the European Central Bank’s 45%.
Covert Intervention and Yen Support
Japanese officials have engaged in covert intervention to support the yen, which quickly becomes visible. At the end of July, the BOJ’s monthly statement revealed intervention of JPY5.5 trillion (approximately $36.6 billion) across what appears to be two operations, slightly higher than earlier market estimates of JPY5 trillion. Since April, Japanese officials seem to have bought around JPY15 trillion to bolster the yen. A powerful short squeeze following the intervention and ahead of the BOJ meeting drove the dollar down from near JPY161.75 to about JPY152.
Yen’s Performance and Future Outlook
The yen gained 7.25% in July, marking its second monthly advance this year and its best performance since November 2022. The BOJ’s adjustment of monetary policy, along with hawkish rhetoric and weak US jobs data, pushed the greenback to JPY146.55, breaking below the uptrend line from the January 2023 and January 2024 lows. Despite stretched momentum indicators, the downside risk for the dollar could extend towards JPY145 and possibly JPY140 in the coming weeks.
Key Takeaways
- Rate Hike: The BOJ raised its overnight target rate by 15 basis points to 0.25% and indicated potential for further hikes if price pressures remain firm.
- Market Reactions: Significant declines in the Nikkei and Topix Bank Index have moderated aggressive rate hike expectations.
- Bond Purchase Reduction: The BOJ plans to halve its bond purchases, reducing them by about JPY400 billion per quarter through the next fiscal year.
- Yen Intervention: Japanese officials have intervened covertly to support the yen, with significant purchases since April.
- Yen’s Performance: The yen’s strong performance in July, driven by BOJ policy adjustments and US economic data, suggests further potential declines in the dollar against the yen.
The BOJ’s recent actions underscore a shift towards a more hawkish stance, aiming to stabilize the economy while managing inflation and currency strength. These developments will continue to shape financial markets and investor strategies in the coming months.
Canada
Bank of Canada Rate Cuts and Economic Conditions
The Bank of Canada (BoC) continued its easing cycle with a key rate cut in July, reducing it to 4.5% after initiating the cycle in June. The central bank’s dovish rhetoric, combined with developments in the US, has led the market to anticipate rate cuts in each of the last three meetings of the year. Despite this, Canada’s two-year interest rate discount to the US did not challenge the 18-year high set in June, slightly above 90 basis points, but was slightly above 70 basis points after the US employment data release.
Inflation and Labor Market Dynamics
Headline Canadian inflation was softer than expected in June, at 2.7%. This moderation in price pressures provides the BoC with the flexibility to address the clear slowdown in the labor market. The unemployment rate has risen from 5.7% in January to 6.4% in June, reflecting a full percentage point increase over the year.
Currency Performance
The US dollar rose to a new high for the year against the Canadian dollar, nearing CAD1.39 before the US jobs report pushed it lower. For the US dollar to suggest a top may be in place, it needs to break below the CAD1.3780-CAD1.3800 range.
Key Takeaways
- Rate Cuts: The BoC has cut its key rate to 4.5% and is expected to make further cuts in the remaining meetings of the year.
- Inflation and Labor Market: Softer inflation at 2.7% in June allows the BoC to focus on addressing rising unemployment, which increased from 5.7% in January to 6.4% in June.
- Currency Outlook: The US dollar needs to break below CAD1.3780-CAD1.3800 to suggest a potential top against the Canadian dollar.
Market Implications
The Bank of Canada’s proactive approach to rate cuts reflects its commitment to supporting the economy amid moderating inflation and a slowing labor market. The interplay between Canadian and US monetary policies will continue to influence the CAD/USD exchange rate, with attention on key support levels that might indicate shifts in market sentiment.
Australia
Reserve Bank of Australia’s Stance and Market Reactions
The Reserve Bank of Australia (RBA) is considered among the less dovish of the G10 central banks. Its hawkish rhetoric has convinced investors that rate cuts are unlikely until well into next year, with the futures market nearly fully pricing in the first cut for mid-Q2 2025. Despite this, the Australian dollar experienced a sharp sell-off in the second half of last month, primarily due to the unwinding of yen carry trades.
Recent Performance of the Australian Dollar
The Australian dollar initially broke above the $0.6600-$0.6700 range, which had been the dominant range since mid-May, reaching a six-month high near $0.6800 on July 11. After a brief period of consolidation, the currency tumbled to $0.6515 two weeks later. This decline appears to have exhausted the position adjustment.
Technical Outlook and Potential Recovery
We suspect that the Australian dollar can recover in the coming weeks, though it may take some time to repair the technical damage from the recent sell-off. The recovery process will likely involve a gradual rebuilding of investor confidence and stabilization in the broader market conditions.
Key Takeaways
- RBA’s Stance: The RBA is among the less dovish G10 central banks, with no rate cuts expected until mid-Q2 2025.
- Australian Dollar Performance: Despite the RBA’s hawkish stance, the Australian dollar faced a sharp sell-off due to the unwinding of yen carry trades.
- Technical Outlook: The Australian dollar’s recent decline suggests an exhausted position adjustment, and a gradual recovery is anticipated in the coming weeks.
Market Implications
The RBA’s relatively hawkish stance compared to other G10 central banks underscores its cautious approach to monetary easing. The Australian dollar’s recovery will depend on both domestic economic conditions and broader market dynamics, particularly the stabilization of carry trade positions and investor sentiment.
Mexico
Mexican Peso Performance and Political Dynamics
In the first half of July, the Mexican peso extended its recovery from the post-election sell-off. President-elect Claudia Sheinbaum’s key cabinet appointments, drawn from the moderate wing of the Morena party, helped ease investor anxiety. The technical expertise of the new cabinet members contributed to this confidence.
Impact of US Election and Market Sentiment
Initially, the peso was sold off as markets assumed a nearly inevitable victory for Trump in the US, which raised concerns about increased pressure on Mexico regarding trade, direct investment, and immigration. However, as US election dynamics shifted, the peso faced renewed pressure from the dramatic unwinding of carry trades against the Japanese yen and a heightened sense of risk-off sentiment as equity markets tumbled. Consequently, the peso gave back its gains from early July, with the US dollar setting new highs for the year near MXN19.2150 after a poor US employment report.
Market Concerns and Economic Indicators
The market remains cautious about President Andrés Manuel López Obrador (AMLO) and his actions in September, when he will have a strong congressional majority for a month before Sheinbaum’s inauguration on October 1. The Mexican economy expanded by 0.2% in Q2, slightly slower than the growth in Q1. While headline inflation improvement has stalled, the core inflation rate continues to edge lower.
Central Bank and Market Expectations
Despite the high degree of uncertainty noted by the central bank, the swaps market has nearly 50 basis points of cuts priced in over the next three months and 180 basis points over the next 12 months.
Key Takeaways
- Political Influence: President-elect Sheinbaum’s moderate cabinet appointments have helped ease investor concerns, but market sentiment remains cautious due to upcoming political developments.
- Peso Volatility: The peso has experienced significant volatility due to both domestic political factors and international market dynamics, particularly the unwinding of carry trades and changes in US election expectations.
- Economic Performance: Mexico’s economic growth slowed slightly in Q2, and while headline inflation has stalled, core inflation continues to decrease.
- Central Bank Outlook: The central bank acknowledges significant uncertainty, with the swaps market anticipating rate cuts in the near and medium term.
Market Implications
The peso’s performance will likely continue to be influenced by a combination of domestic political developments and broader international market trends. Investors will be closely monitoring both the actions of the current administration and the economic policies of the incoming president.
