FX Daily: The Dollar Is Looking Cheap

Photo by Sharon McCutcheon on Unsplash

The sharp rise in US short-term yields, normally a key driver of FX moves, has not been followed by significant strength in the dollar, which makes the USD undervalued (in the short-term) against most G10 currencies. We continue to see upside risks for the dollar. Elsewhere, Japanese officials have started to voice some concern on the yen's high volatility.

USD: Undervalued against most G10 currencies

DXY has risen back above 99.00 at the start of this week, with the dollar moderately benefiting from aggressive market bets on multiple 50bp rate increases by the Fed, which have sent short-term US rates (normally, the main driver of currency moves) sharply higher. Looking at short-term valuation, the dollar is looking cheap against most G10 currencies following the recent moves in yields. Our short-term fair value model – which embeds 2-year swap rate differentials among other variables – shows EUR/USD is now nearly 2.5% overvalued, GBP/USD around 2% overvalued, USD/CAD around 2.7% undervalued.

In periods of large swings in key variables, it is not uncommon to see such stretched levels of mis-valuation. After all, markets may have rushed too much in pricing in 50bp rate hikes by the Fed (8/9 25bp hikes in the price in the next six meetings), and the mis-valuation gap might be reduced first by swap rate differentials shrinking on the back of some easing of hawkish expectations rather than the dollar rallying sharply against its peers.

At the same time, we must acknowledge that the Fed’s openness to 50bp rate hikes has clearly freed up some significant space for dollar appreciation, and this space has been only marginally filled so far, so even if rate expectations don't have much further to run, FX should ultimately catch up with the move in rates and we continue to see the balance of risks for the dollar as skewed to the upside.

Today, markets are keeping an eye on any developments on the Russia-Ukraine peace talks, which have contributed to lifting sentiment at the start of this week. On the data side, we’ll get the first piece of jobs data today with JOLTS openings in the US, before ADP and official payrolls are released tomorrow and on Friday, respectively. Markets will also keep an eye on the Conference Board consumer sentiment, which is expected to have taken a hit from the recent geopolitical tensions and rise in energy prices.

Data, like Fed speakers (John Williams and Patrick Harker will speak later), should play a secondary role in driving the dollar today, and we expect DXY to keep climbing towards the 100.00 mark.

EUR: Only limited respite from peace talks

As discussed above, EUR/USD is now looking overvalued in the short-term after the pair failed to correct sharply on the back of the significant widening in USD-EUR short-term swap rate differential. We estimate the current short-term fair value in the 1.07/1.08 area at the moment.

Indeed, peace talks between Russia and Ukraine are offering some support to the euro, also through the commodity channel as energy prices have halted their rally for now. However, we suspect we’ll need to see continued optimism on this side to keep the EUR/USD afloat given the pressure applied by rising US yields. Interestingly, the pair showed no sign of being oversold (remaining in net-long territory) according to CFTC positioning data as of 22 March – when it was trading around current levels.

We continue to see downside risks for EUR/USD in the near term, even if peace talks offer some temporary respite, and we still expect a break below 1.0900 soon.

GBP: Bailey sends pound lower

There are no UK data releases or Bank of England speakers worth noting today. Yesterday, the pound took a hit after BoE Governor Andrew Bailey delivered some dovish remarks, suggesting a less aggressive stance on tightening due to high levels of economic uncertainty.

The market’s ongoing re-pricing of BoE rate expectations may continue to support EUR/GBP for now, although we still target a gradual move to 0.8300 in the coming weeks as the eurozone appears more likely to suffer from the economic spillover of the Russia-Ukraine war.

JPY: Japan getting nervous about FX volatility

The Bank of Japan has continued to intervene heavily in the bond market in order to curb the slump in 10-year JGBs. Following the BoJ's reiteration that it would conduct unlimited purchases of bonds at fixed rates – the takeup of the operation reached JPY 286bn this morning. Still, 10-year Japanese yields remain dangerously close to the 0.25% yield curve control target's upper-bound (currently trading at 0.249%).

The yen has been on a wild ride on the back of these bond market developments, with USD/JPY briefly trading at 125 yesterday, before correcting lower to the 123/124 region. This morning, Japan's top currency diplomat, Masato Kanda, expressed high concern about the volatility of the yen, which risks harming economic stability, and pledged to work with the US Treasury and other countries to “respond” to excessive FX moves.

We think the yen remains highly vulnerable as long as bond yields continue to press higher – and a return to 125 today is not off the charts. More indications that Japan is taking action to curb JPY volatility could offer some support, but that appears to be a secondary factor compared to keeping yields well within the YCC range.