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We suspect the long-anticipated turn of the US dollar is at hand. The mix of tight monetary policy and loose fiscal policy is coming to an end. The moderation of price pressures for the past three months has boosted the confidence of Federal Reserve officials that inflation is headed back toward its 2% target.

At the conclusion of the July FOMC meeting, Federal Reserve Chair Powell gave his strongest signal yet that a rate cut at the next meeting is likely. Further validation of market expectations may be delivered at the Jackson Hole symposium at the end of August. The jump in the US unemployment rate, following a series of poor labor market data, emboldened expectations for a 50 bp cut to start the cycle.

The easing of monetary policy among the high-income countries is poised to accelerate in the coming months, leaving aside Japan. The easing cycle is expected to continue not only next year, but into 2026. If the recent history is a guide, the key for the dollar's exchange rate is more about US monetary policy than other central banks cutting rates.

This is what happened in Q4 23, which later reversed in Q1 24 as the market unwound the aggressive Fed cuts it anticipated. In December 2023, the Federal Reserve's median forecast was for three rate cuts in 2024. The markets raced to price in more than six cuts by mid-January 2024. The greenback fell dramatically in Q4 23, but recovered smartly in Q1 24 as the markets re-thought its aggressiveness. At the risk of over-simplifying, driven by the shift in Fed policy, we expect similar forces to weigh on the dollar.

There are two new elements in the mix. Since the US presidential debate in late June, and then the assassination attempt, many observers see a second term for Trump as nearly inevitable. Trump and his running mate see the strong dollar as eroding America's competitiveness, and that others have been purposely kept their currencies weak to gain export advantage.

It is this combination of strength and victim messages that appear to have struck a respondent chord among many Americans. That said, President Biden's decision to withdraw his reelection bid has changed the dynamics. At this juncture the electoral contest looks close, and it may come down to a handful of swing states (Pennsylvania, Michigan, Wisconsin, Georgia, and Arizona).

The second new element is deterioration in the US labor market, the triggering of Sahm's Rule (when the three-month average unemployment rate moves 0.5% above the past 12-month low, a recession has always been signaled). Fed policy was set when the US economy overheating. This is no longer the case. The Federal Reserve is likely to ease policy more aggressively than it pointed to in the June Summary of Economic Projections. 

Still, the dollar's role as numeraire was not foisted on the US from foreign powers, but the American officials and banks took it willingly and deliberately after WWII. That was what Bretton Wood codified and implemented. And, when Bretton Woods collapsed after the US unilaterally decoupled the dollar from gold 53 years ago this month, the American officials and businesses strove to sustain the role for the dollar, which it has done through the era of floating exchange rates.

The dollar's role has been understood as an integral instrument of US power projection. Moreover, since 9/11, the weaponization of the dollar (access not price) has allowed the US to check terrorist financing and sanction those that seek to harm American interest. In fact, the extent of the sanctions has given risen to concerns, recognized recently by US Treasury Secretary Yellen, that it is encouraging workarounds, which means different payment systems that do not go through the US dollar or Federal Reserve system.

Coinciding with the turn of the US monetary cycle, the kind of mercantilist policies that are associated with a second Trump term also favors a weaker US dollar. As we have noted in previous commentary, according to the OECD's measure of purchasing power parity, the dollar was recently more overvalued against the yen and euro (German mark) than it was on eve of the Plaza Agreement in 1985, which saw the G-5 countries (Canada and Italy were excluded) coordinate intervention to drive the dollar lower.

The cyclical decline in the dollar, however, should not be confused with de-dollarization. Nor is the key to the dollar’s role to be found in its use invoicing and settling trade even when a US company is not involved in the transaction. There was much talk the echo chamber of the internet that claimed an alleged 50-year-old US-Saudi agreement to price oil in dollars was expired. 

There was no such agreement, but even if some part of OPEC priced accepted other currencies than dollars, it would not challenge the dollar’s role. Saudi Arabia and the U.A.E., for example, peg their currencies to the dollar, which in effects outsources their monetary policy to the Federal Reserve. This means that when the Fed cuts interest rates in September, as we suspect, so will Saudi Arabia and the UAE, as sure as Hong Kong, whose dollar is still pegged to the greenback.

The kernel of truth, though, in the petrodollar claim, is that the origins of the dollar-centric financial system, and the reason it was able to remain the numeraire after the fixed-exchange rate system of Bretton Woods collapsed may indeed lie in the Middle East. 

In late October 1956, a few days after Soviet Union tanks rolled into Hungary, the UK, France, and Israel invaded Egypt. The US was surprised and pressed its financial advantage over the UK, threatening to sell sterling, which was already struggling to maintain its parity level in the Bretton Woods system and block a large IMF package the UK sought. 

Moscow, seeing how America’s special ally was treated and considering its own vulnerability, moved the dollars they had in the US to British clearing banks, and in a somewhat simplified account, you have the origins of the Eurodollar market, the offshore dollar market. Within a couple of years, Moscow was recycling its wheat and oil sales by lending in the Eurodollar market.

The commercial interest of US banks and British banks also played a role. The offshore market was outside the US regulatory jurisdiction and was not bound by Regulation Q, which capped deposit rates. Meanwhile, due to pressure on sterling, the interest rate spread between the UK and the US widened. British banks could borrow dollars and earn a carry.

The Eurodollar market has grown inordinately. According to the Bank for International Settlements, non-US banks have about $50 trillion of dollar debt. When the dollar rises, the cost of servicing this debt increases. It acts as a force multiplier. As the dollar rises against that foreign currency, dollar debtors must sell their own currency and buy dollars to neutralize the impact, chasing it higher. As US interest rates decline and the dollar weakens, foreign companies and countries will be attracted to the low-cost borrowing, and the cycle repeats. 

Currencies from the emerging markets were mixed in July. This is reflected by the MSCI Emerging Market Currency Index, as it posted a small increase (0.30%), while the JP Morgan Emerging Market Currency Index declined slightly (-0.15%).

The unwinding of carry trades added to the pressure on the Mexican peso, which had not fully regained market confidence after the early June national election and the negativity associated with a possible second Trump term. The MSCI Emerging Markets Equity Index snapped a five-month rally with a minor 0.15% loss, leaving it about 6% higher than at the end of 2023.

The MSCI index of developed equity markets rose 1.7% in July to bring this year's gain to 12.7%. Emerging market bonds, as an asset class, also underperformed. The premium of JP Morgan's Emerging Market Bond Index over Treasuries widened slightly above 350 bp in July the most since last November. 

The Bannockburn World Currency Index, a GDP-weighted basket of the currencies from the largest dozen economies, made a marginal new 20-year low in early July. It recovered through the middle of the month but returned to its trough by the end of the month. It eked out an inconsequential gain of slightly less than 0.1% in July. The downside momentum appears to be stalling and we anticipate a recovery in August, which is consistent with a weaker greenback.

The Japanese yen, with a 5.3% weight, was the best performer, with a 7.25% rise in July, helped by intervention, a short-squeeze, and anticipation of a more hawkish Bank of Japan stance, which was delivered at the end of July. Sterling rose 1.7% in July, putting it in second place in the BWCI. It has a weighting of slightly less than 4%.

The strongest developing country currency was the Chinese yuan (0.55%), and it has almost a 23% weighting in our index, second only to the US dollar. The two weakest performances were delivered by the Mexican peso (-1.6%) and the Australian dollar (-1.9%). While several forces were at work, as we note, the unwinding of short yen carry trades appeared to have played a role.

US Dollar

The Federal Reserve did not push against market expectations that the rate cutting cycle will begin in September. Moderating price pressures allows the central bank to take its foot off the brake to bolster the chances that the soft landing can be sustained. The derivatives markets have another cut fully discounted, and about a 70% chance of third cut this year.

Although the economy expanded at a 2.8% annualized pace in Q2 (1.4% in Q1), helped by stronger consumption, government spending, and private investment (which include increased inventories), the quality was suspect, and economists look for a return to the pace seen in Q1 in the second half of this year.

The dollar has been supported by the favorable mix of tight monetary and loose fiscal policy. The upcoming policy mix will likely be less supportive of the greenback. After falling in the first half of July, the Dollar Index recovered in the second of the month. While the upside correction may have a little more room to run, we expect its best days in the extended cycle are behind it.

Euro

The European Central Bank delivered its first rate cut in June, and the market is confident of another cut in September followed by a cut in Q4. The swaps market has almost a 25 bp cut discounted each quarter through the middle of next year. The economy has little forward momentum, expanding by 0.3% in Q2.

European politic tensions have eased, and the European Commission are in place. France has a caretaker government, but there are expectations that President Macron may try to appoint a new prime minister in August. Hungary holds the rotating EU presidency, and his trip to Russia caused greater consternation. Three German states (Saxony, Brandenburg, and Thuringia) will hold elections next month.

Eurozone inflation rose at an annualized pace of 4.0% in Q2, matching the Q1 pace. It rose by less than 1% at an annualized pace in H2 23, suggesting a difficult base effect comparison in the coming months. However, the exchange rate may be sensitive to the more aggressive easing expected by the Federal Reserve over the next several quarters.

The two-year US premium over Germany, which often tracks the exchange rate, has been trending lower since mid-April. It is recorded a new low for the year after the US jobs data on Aug. 2 near 152 bp. The euro peaked in mid-July near $1.0950, its best level in four months. It found support on Aug. 1 near $1.0775, which we expect to hold in in the coming weeks. The high for the year, which will likely be challenged, was set in early March near $1.0980.

Provided below are the indicative closing prices, as of Aug. 2, 2024, of the currency, with the previous prices listed in parentheses.

• Spot: $1.0910 ($1.0715) 
• Median Bloomberg one-month forecast: $1.0845 ($1.0745) 
• One-month forward: $1.0925 ($1.0730)
• One-month implied vol: 5.5% (6.5%)

Japanese Yen

The Bank of Japan acted decisively. It hiked its overnight target rate by 15 bp to 0.25%. Provided that price pressures remain firm as officials expect, additional rate hikes have been signaled. The swaps market is discounting a 10 bp increase by the end of the year. The 13% decline in the Nikkei in the past three weeks, as well as the more than 11% drop in the Topix Bank index in the past two weeks, have served to rein in more aggressive expectations.

The BOJ also announced plans to reduce its bond purchases by about JPY400 billion a quarter through the end of the next fiscal year. This essentially will halve its purchases and put them below the amount maturing. The BOJ’s balance sheet is about 128% of GDP. In comparison, the Federal Reserve's balance sheet is about 25% of GDP and the European Central Banks balance sheet is around 45% of GDP.

Japanese officials have taken to covert intervention, but it quickly becomes visible. At the end of July, the BOJ's monthly statement showed intervention of JPY5.5 trillion (or about $36.6 billion) in what appears to be two operations. The earlier market estimate was JPY5 trillion. Since April, Japanese officials appear to have bought about JPY15 trillion to support the yen. A powerful short squeeze after the intervention and ahead of the BOJ meeting helped drive the dollar from near JPY161.75 to about JPY152.

The yen gained 7.25% in July, its second monthly advance this year and its best performance since November 2022. The BOJ's adjustment of monetary policy, hawkish rhetoric, and weak US jobs data pushed the greenback to JPY146.55 and below the uptrend line off the January 2023 and January 2024 lows. Although momentum indicators are stretched, the downside risk for the dollar may extend toward JPY145 and possibly JPY140 in the coming weeks. 

• Spot: JPY146.55 (JPY160.90) 
• Median Bloomberg one-month forecast: JPY151.40 (JPY158.20) 
• One-month forward: JPY145.85 (JPY160.15) 
• One-month implied vol: 11.8% (9.5%)

British Pound

In a 5-4 vote, where Governor Bailey cast the deciding vote, the Bank of England delivered its first rate cut in the cycle on Aug. 1. Besides saying that the decisions will be made on a meeting-by-meeting basis, there was not much forward guidance. Still, the swaps market is undeterred and has another cut fully discounted at the November BOE meeting, and it seems nearly convinced of a third cut this year.

The best inflation news is probably behind the UK for several months. The BOE recognizes this, and its median forecast is for inflation to bit at 2.3% in Q3 and 2.7% in Q4. It was at 2.0% in June. In Q3 23, UK's CPI rose at annualized rate of 1.6% and less than 1% in Q4 23. It will be difficult to match that this year.

The new government seems committed to fiscal consolidation and the Office for Budget Responsibility projects the deficit in the new fiscal year may fall below 3% for the first time since 2019. The pullback since July 17, when sterling set the high for the year near $1.3045, looks corrective in nature and may have been completed near $1.27. A move above $1.29 could signal a retest on the 2023 high near $1.3140.

• Spot: $1.2800 ($1.2645) 
• Median Bloomberg one-month forecast: $1.2700 ($1.2630) 
• One-month forward: $1.2810 ($1.2650) 
• One-month implied vol: 6.3% (5.9%) 

Canadian Dollar

The Bank of Canada cut its key rate in July (to 4.5%) following an initiation of the easing cycle in June. The dovish rhetoric and US developments have encouraged the market to price in a cut in each of the last three meetings of the year. Still, Canada's two-year interest rate discount to the US did not challenge the 18-year high set in June slightly above 90 bp. It was a little above 70 bp after the US employment data.

 Headline Canadian inflation was softer than expected in June (2.7%). The moderating price pressures give the central bank the leeway to begin addressing the clear slowdown in the labor market. The unemployment rate has risen from 5.7% in January to 6.4% in June, a full percentage point higher than in June 2023.

The US dollar rose to a new high for the year against the Canadian dollar near CAD1.39, before the US jobs report pushed it lower. Still, it needs to break below CAD1.3780-CAD1.3800 to suggest a top may be in place. 

• Spot: CAD1.3875 (CAD 1.3680) 
• Median Bloomberg one-month forecast: CAD1.3775 (CAD1.3650) 
• One-month forward: CAD1.3860 (CAD1.3670) 
• One-month implied vol: 4.9% (4.9%)

Australian Dollar

If the Bank of Canada is seen to be among the dovish G10 central banks, the Reserve Bank of Australia is among the less dovish. The hawkish rhetoric of the central bank has persuaded the investors that even if it does not raise rates, the RBA is unlikely to cut rates until well into next year. The futures market has the first cut nearly fully discounted for mid-Q2 25. Yet, such views were not able to prevent a sharp sell-off in the Australian dollar in the second half of last month, as yen carry-trades were unwound.

The Australian dollar began last month breaking to the topside of the $0.6600-$0.6700 range that dominated activity since mid-May. It reached a six-month high near $0.6800 on July 11, and after a brief consolidation, it tumbled to $0.6515 two weeks later. We suspect that exhausted the position adjustment and the Australian dollar can recover in the coming weeks, but it may take some time to repair the technical damage.

• Spot: $0.6520 ($0.6670) 
• Median Bloomberg one-month forecast: $0.6625 ($0.6680) 
• One-month forward: $0.6525 ($0.6675)
• One-month implied vol: 9.5% (8.1%) 

Mexican Peso

In the first half of July, the peso extended its recovery from the post-election sell-off. President-elect Sheinbaum's key cabinet appointments were from the moderate wing of the Morena party. The technical expertise of the cabinet may have also helped ease investor anxiety. When many assumed a Trump victory in the US was nearly inevitable, the peso was sold as part on ideas that more pressure would be brought to bear on Mexico on trade, direct investment, and immigration.

Yet even when the US election dynamics changed, the peso was hit by the dramatic unwinding of carry-trades against the Japanese yen, and the heightened sense of risk-off as equity markets tumbled. The peso gave back in full, more than the gains scored in the first half of July. The US dollar set new highs for the year after the poor employment report near MXN19.2150.

The market remains wary of what AMLO will do in September, when he has a strong congressional majority for a month before Sheinbaum is inaugurated on Oct. 1. The economy expanded by 0.2% in Q2, slightly slower than in Q1. Improvement in the headline inflation has stalled, but the core rate continues to edge lower. While central bank notes the high degree of uncertainty, the swaps market has nearly 50 bp of cuts discounted over the next three months and 180 bp over the next 12 months.

• Spot: MXN19.18 (MXN18.32) 
• Median Bloomberg one-month forecast: MXN18.61 (MXN18.06) 
• One-month forward: MXN19.27 (MXN18.41) 
• One-month implied vol: 15.3% (14.5%)

Chinese Yuan

The yuan fell every month in H1 24 before rising by about 0.55% in July, even though it surprised the market by delivering a small rate cut. The yuan's weakness had pushed out rate speculation to later in Q3. However, disappointing Q2 GDP (4.7% year-over-year, down from 5.3% in Q1) and soft June CPI (0.2% year-over-year) spurred the PBOC to cut rates. Its monetary policy tools are shifting, and it raised the significance of the seven-day reverse repo rate, which is cut by 10 bp to 1.7%.

The banks quickly followed with a similar cut in the prime rates, and then the PBOC cut the previous benchmark one-year Medium-Term Lending Facility Rate by 20 bp (to 2.30%). More economic measures look necessary if Beijing is to reach its growth target of 5%. 

Efforts to curb Chinese export penetration is spreading from high income countries to more in the Global South. The unwinding of carry-trades and the broad dollar weakness, especially against the yen, seemed to bolster the yuan more than the formal and informal measures that officials rely on to manage the exchange rate.

The dollar sunk to nearly CNH7.14 after the disappointing US employment data, its single biggest daily decline since March 2023. The price action reaffirms our sense that the yuan's exchange rate is largely a function of the broad direction of the dollar and the state of carry-trade strategies. The US TIC data showed Chinese investors sold a record $42.6 billion of long-term US securities (Treasuries, agency, and corporate bonds, and equities). China announced measures that discourage equity short sales, and officials are considering dramatically raising the fees associated with high-frequency trading.

• Spot: CNY7.17 (CNY7.2675) 
• Median Bloomberg one-month forecast: CNY7.2150 (CNY7.2615) 
• One-month forward: CNY7.11 (CNY7.13665) 
• One-month implied vol: 4.9% (4.8%) 

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