The hawkish signal from the recent FOMC meeting weakens the case for being bearish over the USD in the medium term. The Fed’s senior leaders remain reluctant to start tightening monetary policy but there is a bias among the regional governors to be less dovish. Further repricing on an accelerated Fed rate path, which will likely be associated with USD appreciation and higher real rates, could still happen if the upcoming US payroll/inflation numbers surprise on the upside.
Source: Bloomberg, Bank of Singapore
It is premature for a broad USD rally. We are more confident that the Fed shift would lift FX volatility, than that they have decisively turned the broad USD cycle around.
But the USD outlook has turned from bearish to more mixed for low-yielding reserve currencies, particularly the EUR and CHF. Strong European growth is set to keep the EUR supported. However, divergence between a more hawkish Fed and still dovish ECB is likely to limit EURUSD upside, keeping it rangebound. We lowered our 12-month EURUSD forecast to 1.21 from 1.25. The practical investment conclusion is that the EUR and CHF could join the JPY as funding diversifiers further down the road. Ahead of Germany’s election in
September, the material shift in opinion polls away from a Green-Left coalition that would have been more EUR supportive, removes another source of upside for the EUR.
The Fed won’t be the first of the G10 central banks to tighten policy. But the hawkish Fed tweak brings the Fed a step closer to the hawkish camp that currently includes the Bank of England, Bank of Canada, Reserve Bank of New Zealand and Norges Bank.
The time to start worrying about the sustainability of the reflation trade, commodity downswing and broad upturn in the USD cycle is when business confidence indicators such as the PMIs roll over. We are not there yet with the June flash PMI still pointing to a rebound in growth in 2Q21 and 3Q21 across the developed markets, concentrated in the services sector.
G10 commodity currencies (i.e., AUD, NZD, CAD and NOK) should hold up well, as industrial commodity prices are likely to stay elevated given robust global recovery from the pandemic while risky assets should cope with higher yields. The latest news also shows progress with bipartisan infrastructure deal in the US, which if approved, is supportive of industrial commodities. But the stronger USD backdrop is likely to limit the G10 commodity currency appreciation to a smaller extent than we previously expected.
A less carry-friendly backdrop for EM currencies is expected post-FOMC. Differentiation is necessary, as there is still scope for selective EM currencies to remain resilient, especially where the central banks have turned hawkish (i.e., Brazil and Russia) or just started to tiptoe into tightening (i.e., Mexico).
The broader picture points to Asia lagging behind the rest of EM in policy rate hikes. Within Asia, Korea seems most ready for a rate lift-off by end-2021, which could point to room for KRW to play catch-up. The CNY appreciation trend will stay intact given the supportive current account surplus, interest rate differentials and portfolio flows with FSTE World Government Bond Index inclusion to start from October. But headroom for CNY appreciation could be more limited. We now target USDCNY at 6.25 in a year’s time instead of 6.15. The CNY should remain a stable anchor for Asian currencies.Disclaimer applicable to recommendation
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