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Wealth Insights | Currencies - Weekly Houseviews and Strategy

Will higher rates support further DXY gains?

  • USD: UST yields have surged sharply higher over the past fortnight and US rates markets now discount a more rapid rise in Fed policy rates – a cumulative 200bp of hikes from the current 0.25-0.5% Fed Funds rate. In FX though, rising UST yields have had a relatively muted impact on DXY that seems to be languishing in a 96.5 – 99.0 range with weakness against commodity FX (AUD, NZD, CAD), resilience against the euro bloc (GBP and EUR) and strength vs JPY. The fading impact of higher UST rates on DXY may be due to the progressive flattening of the UST curve as rates rise – perhaps signaling a higher bar for further rate rises. This suggests DXY direction will increasingly need to come from outside the US with support potentially from continuing (and possibly escalating) geopolitical tensions or a deeper and extended downturn in China and Europe, while a cessation in Russia–Ukraine hostilities and/ or a more rapid easing in global supply constraints could lead DXY to weaken.  
  • EUR: The ECB’s imprecise guidance for policy normalization seems to be leaving a vacuum for euro rates to test higher even as UST yields have lost some upside momentum for now. For EUR though, sentiment effectively boils down to a view that (1) the terms of trade shock from higher energy prices may extend further; and (2) the ECB is unlikely to tighten as quickly as what euro area rates are currently pricing (four 25bp hikes over the next 12 months), given the plunge in euro area economic sentiment. That said, the majority of ECB council members still favor policy normalization by year-end due to soaring inflation, but still well behind the Fed. Concerns about China’s outlook could also add to headwinds for EUR, given Europe’s strong trade linkages. And this leaves EUR’s status as a funding currency intact for now.  
  • GBP: The BoE MPC seems to be caught between a rock and a hard place. Market-based UK inflation indicators still remain elevated while BoE’s focus is shifting to softening domestic demand conditions (given the growth and terms of trade shock from high energy prices). But elevated longer-term inflation risks cannot be ignored given the risk of inflation expectations becoming embedded amidst a tight jobs market. Where does this put sterling? It is clear sterling has not benefitted from the recent rate hikes by the BoE as markets view the BoE having little appetite to embark on an extended tightening cycle. That said, rates do matter and higher BoE rates are probably behind the support for cable in the low 1.30s.   
  • AUD: Despite the improving domestic outlook, Australian rates still price a relatively aggressive tightening outlook for the RBA relative to Citi analysts. Market rates therefore are unlikely to provide much further support for AUDUSD unless the RBA validates market pricing. From a terms of trade perspective, the AUD also looks expensive relative to the Asia FX basket and China’s Li Keqiang economic activity index. However, AUD still continues to outperform EUR (hit by the growth and terms of trade shock) and JPY (weighed by the dovish BoJ). 
  • RMB: With the new Covid wave covering 16.7% of China’s GDP, Citi analysts estimate semi-lockdowns could cost 0.5-0.8/1.0-1.6ppt of China’s GDP growth in 22Q1. This means policy support remains essential to sustain China’s growth momentum, and the easing cycle is therefore unlikely to be over, especially while China retains its “dynamic zero-Covid policy”. Concerns about the new Covid impact on the Chinese economy are therefore now starting to replace RMB’s earlier bid as an alternative settlement and reserve currency following the Russia – Ukraine conflict. 

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