FX Daily: Dollar Rally Needs More Risk-Off Fuel

Contagion from AI to defensive stocks in the US and worldwide allowed the dollar to rally even before the strong US jobs market report. But unless risk sentiment remains poor this week, lower front-end US rates should favor a weaker dollar, even if inflation tomorrow comes in slightly hotter than expected.

We think the dollar rally looks a bit stretched.

USD: At risk of correction

The dollar has emerged stronger after markets digested last Thursday's big tech-led equity selloff. The greenback was already gaining ground across the board even before US payrolls (165k) smashed expectations on Friday afternoon. The dollar's appreciation was probably driven, albeit with some delay, by the extent of the contagion into defensive stocks and global markets.

Still, the pass-through from the equity shake-off to FX volatility has been rather contained, and broadly concentrated in higher-beta G10 currencies. The Australian dollar, Swedish krona and Norwegian krone have dropped around as much as the heavily AI-exposed Korean won since last Wednesday's close.

Scrutiny of the AI trade will inevitably remain very elevated this week. Markets are still assessing the actual implications of the Democratic sweep of Congress for regulatory risks around the AI-capex cycle, and whether this is effectively the start of a bigger downturn for tech stocks.

We think the dollar rally requires the risk-off mood to persist this week. Otherwise, there is some moderate correction risk, as Friday’s move looked a bit too stretched relative to short-term market drivers. Still, in our view, the macro story should prevent DXY from returning to last week’s lows of 101.1. We expect tomorrow’s October US CPI to come in at 0.3% month-on-month for both headline (consensus 0.3%) and core (0.3%). That should help cement expectations for a December Fed hike (19bp priced in), making the swap curve more protected from other equity market shocks.

Oil remains the other variable to watch. Brent has stabilised just below $100/bl, retaining some geopolitical risk amid timid progress on peace negotiations in the Gulf and a lack of clarity around the implications of US and Israeli political developments. In Israel, opposition candidate Gadi Eisenkot, who has supported a more diplomatic approach towards Iran than Prime Minister Benjamin Netanyahu, has been given the mandate to form a government. He has six weeks to form a coalition, and failure to do so is likely to result in Netanyahu receiving the mandate again.

EUR: Cheap, focus on ECB succession

The drop in EUR/USD looks too sharp relative to its short-term rate differential. We estimate short-term undervaluation at around 2.1-2.3%, exceeding what has been justified by the French risk premium. That’s mostly because front-end rate differentials have actually tightened on the back of the stock market turmoil, compensating for worsening risk sentiment. Unless risk sentiment faces new instability this week, we expect EUR/USD to make its way back above 1.120.

The eurozone data calendar is quite quiet this week, but focus on the European Central Bank's succession story will increase. Today’s Eurogroup meeting will discuss the candidacies of Spain’s Pablo Hernández de Cos and the Netherlands’ Klaas Knot, the only two officially running for the role – although last-minute contenders might still emerge. Knot is a hawk and de Cos is a dove, so there should be some reaction accordingly in the euro depending on who ends up taking the role.

However, the reshuffle will also involve a broader bargain around the roles of Chief Economist and Executive Board member, currently held by Philip Lane (moderate dove) and Isabel Schnabel (hawk), which will be weighed by markets too. Overall, the impact on the euro may prove relatively contained and short-lived. There are 21 voting rights for monetary policy decisions at the ECB, and we don’t see any candidate willing to cause seismic changes at this time of elevated uncertainty.

GBP: Still too expensive vs EUR

EUR/GBP continues to trade sharply below its short-term fair value, by around 2.6-2.8% according to our models. That continues to reflect the euro’s idiosyncratic premium related to French risk (EUR/GBP has been one of the favourite channels), but even accounting for that, the decline in the pair looks a bit too stretched.

Today, we’ll hear from Bank of England Governor Andrew Bailey following last week’s hawkish hike. The lack of dovish dissenters in November reinforced our view that the BoE will hike again in February, with some risk already in December. However, as we note here, consensus around another rate increase will likely be harder to achieve next time, as some members are considering a one-and-done approach as a possibility.

Most importantly, Bailey himself has signalled caution in hiking more than once again. Market pricing for three more cuts remains far too aggressive in our view, and argues – alongside short-term valuation signals – against further sterling strength against the euro. A return to 0.840 in EUR/GBP remains the most realistic move in the coming weeks, in our view.

CEE: Rate hike outpricing leaves region exposed to risk-off mood

The region is recovering from a global sell-off, as well as from hawkish and dovish surprises delivered last week by the National Bank of Poland and the Czech National Bank. While the global narrative remains the primary driver, a few data releases on this week’s calendar could impact the market.

On Tuesday, Hungary’s October inflation figures will be released. We expect an increase from 1.9% to 2.1%, while the National Bank of Hungary anticipates 2.0%. We expect monthly inflation of 0.4% for September, driven primarily by fuel and clothing prices – the latter largely reflecting seasonal factors. In the Czech Republic, inflation is expected to be confirmed at 2.4%, with core inflation rising slightly from 3.1% to 3.2%.

On Thursday morning, Romania will release its October inflation data, which we expect to show a further increase from 6.6% to 6.9%. The National Bank of Romania is likely to keep interest rates unchanged at 6.50%. In Turkey, the Central Bank of Turkey will publish an inflation report following the rate cut implemented two weeks ago.

On Friday, Romania and Poland will release flash Q3 GDP data. We anticipate an acceleration in economic growth for the former and a slowdown for the latter. The CNB will release the minutes from last week’s meeting, when it hiked rates for the second time since the onset of the US-Iran conflict, while Turkey will release its inflation expectations for November.

Regional markets have seen a sharp downward shift in rates, driven by the global sell-off and several surprises from central banks. Following the CNB’s rate hike and the subsequent market rally, market pricing now implies roughly one and a half rate hikes for the Czech Republic. In Poland, the market has priced in just under three rate hikes; in Hungary, it anticipates approximately one rate cut. In our models, narrower rate differentials and a stronger US dollar point to weaker CEE currencies once again, leaving us generally bearish.

In the short term, however, the recent decline in energy prices and discussions regarding a diplomatic solution to the US-Iran conflict may sustain some optimism within emerging markets, tempering the pressure from other negative factors. Following the CNB’s dovish stance last week, we expect EUR/CZK to head toward the 24.350–24.400 range. We see EUR/PLN in the 4.400-4.410 range. EUR/HUF has likely touched local lows, and we see potential for an upside here as well.