The US dollar: making hay while the sun shines
The large USD1.9tn fiscal stimulus nearing approval by the US Congress has made the US dollar more attractive by improving the growth differential between the US and the rest of the world in the short term. More importantly, this boost to the US economic outlook has led to upward pressure on US long-term yields, thus supporting the dollar—notably against low-yielding currencies such as the Swiss franc and Japanese yen. The sharp rise in yields has started to weigh on cyclical currencies like the Australian dollar and Canadian dollar that had previously held up against the US dollar. Overall, the current environment of higher yields is proving positive for the US dollar against other currencies.
But while it could continue for a while, we believe that dollar strengthening is unsustainable. At the core of our scenario is our belief that US inflationary pressures will dissipate despite large fiscal stimulus packages and the reopening of major economies. Without a sustained rise in inflation, the Fed will remain accommodative, in line with its new ‘average inflation targeting’ framework. The market now expects the Fed to raise rates at end-2022. Our belief that the US economy will probably be facing tighter fiscal policy at that point is another reason why we do not think the Fed will raise policy rates as early as the market is discounting. A possible strengthening of the Fed’s forward guidance would ease concerns about an early rate hike, thus supporting risky assets and sucking support from the safe-haven US dollar.
In the absence of a hawkish Fed, we have difficulty believing that the US growth outlook will be strong enough to boost the US dollar on its own, especially as other major economies are also recovering. And we cannot imagine there will be significant divergence in central banks’ monetary policies when the whole world is in recovery mode. Finally, the likely deterioration in US twin deficits suggests increased downward pressure on the dollar over the long term.
Overall, we are sticking to our medium-term bearish view on the US dollar, although the magnitude of the dollar’s downward potential has declined in the medium term. Our 12-month target on the EUR/USD rate is now USD1.25 (vs. USD1.27 previously). We also remain cautious in the short term, with a three-month forecast of USD1.18 (vs. USD1.19 previously). At the same time, we have decided to significantly revise our forecasts on the USD/JPY rate, seeing the Bank of Japan’s explicit yield-curve-control as particularly penalising for the yen. Our three-month forecast for the USD/JPY rate is now JPY108 (vs. JPY104 previously), while our 12-month forecast stands at JPY107 (vs. JPY100 previously).