After speeding ahead in 1Q21 on expectations for US growth out-performance, the USD has since pared gains as hopes for European growth improved. There are signs that Europe is catching up with the US’s vaccination rollout, dampening the market’s view on US exceptionalism in favour of a broader global recovery.
USD pared gains after speeding ahead in 1Q21 as US vaccine exceptionalism fades
Source: Bloomberg, Bank of Singapore
Stalling US bond yields despite boomy US data also weighed on the USD. The Fed remains dovish and is set to look through inflation pickups. This reflects the shift in its reaction function designed to engineer an inflation overshoot. The Fed sounded a little more upbeat on the economic outlook in the April FOMC but gave no signal that it was inching towards tapering. This contrasts with the more hawkish Bank of Canada, which has started tapering its asset purchases, and, together with the Norges Bank, has discussed raising policy rates before the end of next year.
We expect some modest USD weakness for the rest of the year as the global economic recovery gains momentum. As global vaccine efforts pick up, this should also embolden the thinking that it will not just be the US economy that is recovering.
Taxes on US corporate profits are likely to rise. As a result, we expect investors to increasingly search for returns in non-US markets to the detriment of the USD.
However, there are risks to our weaker USD view. First, substantial US stimulus creates an overheating threat. Underlying US inflation could rise more than expected in the coming months and remains persistently high, contrary to the Fed’s expectations of inflation being transitory. This could force the Fed to turn more hawkish. US real rates could rise and bring the USD with it.
Second, a shift from a clear risk-on reflationary environment to a muddier risk backdrop could limit the USD’s decline via the risk sentiment channel. We believe the USD’s inverse relation to risk appetite remains a dominant feature. Increasingly, risky assets may have to grapple with whether to continue to welcome strong growth or be wary of peak growth. Solid US growth in 1Q21 was supported by economic re-opening and robust fiscal stimulus. Following a strong economic rebound, can good news remain as good news, as investors eventually adjust to a slower rate of growth than before?
We remain positive on the CNY and GBP. The deterioration in market sentiment on Chinese assets caused by regulatory actions in the technology sector and the credit clean-up took some shine off the CNY. But these headwinds should not affect the CNY’s direction of travel in favour of further appreciation in the medium term. Prospects of tapering by the Bank of England is GBP-positive. But the GBP may face some near-term volatility around the Scottish Parliament election, which will shed light on whether Scotland will hold a second independence referendum.
We continue to like G10 commodity currency exposure amid a significant rebound in global growth currently underway. The JPY remains an attractive funding diversifier. Bank of Japan looks set to remain much more dovish for longer relative to its G10 peers. This would constrain the ability of Japan’s 10-year yields to keep pace with higher US yields in the medium term. The path for USDJPY therefore seems well supported. Our 12-month forecast for 10y US Treasury yield and USDJPY remain at 1.9% and 110 respectively.
