FX Daily: Dollar Finally Catching Up With Its Drivers

The dollar had a strong start to the week, finally realigning with a set of supportive short-term drivers: front-end rates, higher energy prices and soft risk sentiment. We could see some stabilisation ahead of tomorrow’s key FOMC announcement, but risks remain on the upside for USD. Elsewhere, we have little faith in this GBP outperformance.

The dollar is having a strong start to the week..

USD: Finding strength

US 10-year yields touched 5.0% yesterday. As our rates team discussed here, that’s no reason to panic: 5% is a tolerable 50bp premium over the upper bound of our estimate for the neutral 10y rates (4.0-4.5%).

The relevant question for FX is whether that represents a pain threshold for the Treasury. Markets were disappointed with the $6bn buyback operation, meaning any new intervention has a clear higher bar. Remember, larger unscheduled buybacks should be dollar-negative regardless of their effectiveness in capping yields. For now, Scott Bessent may be willing to let a largely oil-fuelled bond rout run its course, perhaps counting on Wednesday’s likely Fed hike to at least keep inflation expectations from breaking loose.

Yesterday, the dollar finally caught up with the tailwinds we’ve highlighted over the past couple of weeks: supported front-end rates, high oil prices, and a soft risk environment. Yesterday was DXY’s strongest session since the day of Warsh’s Jackson Hole speech. What’s surely helping the index is the yen losing much of its idiosyncratic push. USD/JPY was briefly back at 155.0, and as we discussed yesterday, we think upside risks extend to 156-157 in the near term.

The most realistic driver of a USD correction today is any positive development in the Gulf. The latest headlines on reduced Saudi output and delayed negotiations have continued to support Brent at around $107/bbl.

The dollar may stay in tighter ranges until the FOMC delivers its verdict tomorrow evening: today’s calendar includes only the Empire Manufacturing and weekly ADP payroll figures. Still, the broader backdrop keeps the odds in favour of further dollar gains, in our view. DXY at 100.0 remains a credible near-term target.

EUR: 1.150 in sight

This morning’s ZEW in Germany is expected to keep improving. Consensus is looking at a jump from 34 to 40 in the expectations gauge and from -61 to -52 in the current situation one. That’s effectively the only data release with any market-impact potential this week – unless final August CPI prints show large revisions. Anyway, the echo of last week’s hawkish ECB hike remains a more relevant driver for any euro resilience at this stage.

Our models suggest EUR/USD is close to its short-term fair value model, slightly leaning towards undervaluation. That said, global equities and short-term rates have the highest betas on EUR/USD at the moment: a risk-off, hawkish hike by the Fed tomorrow could easily take the pair to our 1.150 short-term target.

GBP: Not trusting the EUR/GBP downtrend

The pound has shown good resilience to the dollar’s advance. EUR/GBP is down by around 0.5% since Friday, perhaps on some precautionary positioning ahead of the Bank of England meeting on Thursday.

But as discussed in our preview, we think the risks are actually on the dovish side this week. Unlike the ECB, we suspect BoE doves will hold their ground and stress that there is no evidence price pressures are extending beyond energy prices. We also see some risk that Governor Andrew Bailey himself pushes back against aggressive market pricing (45bp by December, 100bp by June).

We struggle to see EUR/GBP falling much further from here. Most risks appear on the upside in the coming weeks, from the monetary policy story mentioned above to potential fiscal headlines ahead of the late October budget to growing pressure on Downing Street to allow independence referendums in Scotland, Wales and Northern Ireland. Our target remains 0.87 for EUR/GBP.

CEE: Higher rates offer currencies a buffer after the global shock

The regional calendar is relatively light this week, with Thursday’s CNB meeting the only key event. With local developments having limited market impact, global drivers have taken centre stage. Yesterday’s shock – a post-weekend surge in energy prices, a rise in the 10-year US Treasury yield to 5%, and a stronger US dollar – hit CEE markets hard, weakening currencies and sharply repricing rates higher across the curve. Front-end markets in the CEE3 priced in an additional 10-20bp of rate hikes on average. Although risk-off sentiment is likely to persist today, higher front-end rates should help cushion currencies against further losses and create scope for stabilisation.

Our EUR/CZK view is broadly unchanged: we expect the pair to approach Thursday’s CNB meeting near 24.300, with further upside if the central bank adopts a dovish tone versus market pricing, which is our baseline. The EUR/PLN rate differential recorded the region’s largest increase yesterday and the zloty could stabilise below 4.340 as markets look through dovish comments from MPC members after the NBP decision. EUR/HUF remains vulnerable, reflecting its typically high sensitivity to gas prices, and may rise further. With the Hungarian market still pricing in roughly one rate cut, the forint could again test levels above 368. Support may not emerge until next week’s NBH meeting, which we see as carrying hawkish risks.