Are the stars all aligned?

The USD weakened further in September triggered by more Fed rate cut expectations. US soft-landing, Fed easing and China stimulus all point to further USD weakness. However, there are several risks that could lead to a different outcome. As a result, we believe the USD will stay in its current range until the end of the year but not necessarily uniformly against all currencies. In our view, the AUD and the JPY have good chances to outperform.

The USD DXY fell 1.1% in September to the low-end of its two-year range as the market bet on more Fed easing. USD weakness was broad-based but most noticeable versus high-beta currencies such as the AUD and the GBP. The performance of EM currencies was mixed, but on balance positive as well with the BRL and the ZAR outperforming all major currencies. More broadly, September was not a bad month for financial markets as it is often the case (see our previous QCAM Monthly). The start was gloomy but then sentiment recovered, stocks rallied, Treasury yields fell, gold rose and most currencies appreciated versus the USD.

The start of broad-based USD weakness …

October has started again gloomy due to the escalation of hostilities in the Middle East. Geopolitical risks aside, however, the last few weeks have contained a string of good news that if realized could result in broad-based USD weakness, also given its overvaluation against most major currencies (see pages 5 & 6). First, more signs that the period of US exceptionalism is ending with a soft landing for the US and global economy in reach. Second, the Fed has started to ease and is projecting to lower the Funds rate to neutral (around 3%). Third, China has announced a new stimulus package with the promise to do more if necessary. The reasons for optimism are justified, but we also see significant risks that could lead to very different outcomes at least in the near term.

… is not assured

We agree that soft-landing is the most likely scenario for the US and global economy, but we also think that the probabilities of the risks around the soft-landing scenario are significant. For the US, economic and inflation resilience as well as recession are both in play and rather supportive for the USD. Resilience would mean more US exceptionalism while recession would probably trigger risk aversion. Furthermore, we are sceptical that the Fed will cut as much as the market currently expects even if soft-landing is achieved. Supply-demand dynamics for goods, services and capital have changed and require, in our view, tighter monetary conditions to keep inflation under control.
China’s efforts over the last two years to revitalize the economy have not been successful. In our view, the latest announcements and the promise to do more if needed are different but success is not automatically guaranteed. The structural problems created by the overinvestment in real estate and state-owned enterprises are immense and the government’s increasingly interventionist approach to industrial policy is not making them smaller. As a result, the euphoria over China’s stimulus announcements could soon fade, while it takes longer until the impact becomes visible in the economy, if at all.
The other concern is the ongoing economic slump in the Euro-area. While the US economy is slowing to a moderate pace, the Euro-area has been stagnating at the brink to recession for nearly two years and there are no signs of imminent improvement. Especially Germany and France are struggling with structural and fiscal impediments and the political situation in both countries has deteriorated to a point that make a quick turnaround unlikely. As a result, the need for monetary stimulus is much larger compared to the US. Against that background, it is surprising how well the EUR is holding up, which may be thanks to the Euro-area’s current account recovery (see chart). This may change once the market realizes that the ECB has to ease more than the Fed.
Finally, there is the US election wild card. The last few weeks before the election as well as the outcome and reaction could raise uncertainty. One result could be a much more restrictive trade policy, especially versus China. This would be bad for everyone, but probably less for the US than for others, which would be USD positive.

High-beta and safe-haven

If the stars all align, risk sentiment improves and the USD enters a broad-based decline, high beta currencies are likely to perform best. Among them, we like the AUD most. Australia is well positioned to benefit from a rise in commodity demand, especially if China does manage a recovery. The Australian economy itself is solid but inflation is running on the high side. As a result, we think the RBA will be slow to follow other central banks in cutting interest rates. We also like safe-haven currencies as a hedge. The CHF stands out but has the handicap that the SNB will probably resist more currency appreciation. In contrast, the new Japanese leadership and the BoJ are not opposed to a JPY recovery, given its huge undervaluation. The Japanese economy is not outperforming but it has held up better than feared. As a result, we expect the BoJ to continue its policy normalization, which means not only raising interest rates but also reducing the balance sheet, which we see as JPY positive over time.

QCAM MONTHLY | 03.10.2024 | Issue #108