Position for dollar weakness

The Fed is coming closer to the end of its rate hike cycle. The timing of possible rate cuts remains uncertain, and therefore investors need to prepare for volatility in the US dollar as market expectations continue to shift. Still, US inflation continues to fall, while economic growth is likely to decline as the effects of higher rates are felt. The general direction of a weakening USD seems clear, and international investors have strong incentives to repatriate funds out of the US.

Investors worried about the risk of a financial crisis can consider diversifying into traditional safe havens like the Swiss franc or gold. Economic conditions in Switzerland call for tighter monetary policy, and we think the Swiss franc is due to appreciate further. Swiss inflation is moderate relative to other countries, and the Swiss National Bank is committed to reducing its large balance sheet. A slow but steady appreciation of the CHF should also shield Switzerland from potential financial market turbulence.

We see gold as an attractive portfolio diversifier as well as an effective hedge against scenarios in which real interest rates fall. A rising probability of a US recession, fears about financial and geopolitical instability, the prospect of less aggressive Fed policy, and a weaker US dollar should all support gold. We recently increased our 12-month price target to USD 2,200/oz, and recommend investors make use of the precious metal's volatility to generate yield or add on dips.

The Fed is approaching the end of its rate-hiking cycle, while recent comments from European Central Bank officials suggest that the job of tightening monetary policy in the Eurozone is not yet done. This should decrease the interest rate differential between the two blocs sharply, while the growth differential between the US and Europe should also fall in the coming months. Higher bond yields and a decline in the yield spread to the US should also bring a more balanced financing situation, further supporting the euro.

We also expect sterling to strengthen against the US dollar. The pound should be supported by an erosion of the US growth and interest rate premium, while it continues to trade at a meaningful discount to the dollar. In addition, a less volatile UK political backdrop has left fiscal policy back on sounder footing, and relations with the EU are thawing. Both developments substantially reduce the downside risks for investors holding the pound.

We expect the Bank of Japan (BoJ) to eventually follow all other G10 central banks and tighten its ultra-loose policy. Japan was a laggard in reopening its economy after COVID-related lockdowns. Consequently, inflation, employment, and house prices rebounded later than in other G10 countries. The macro trends speak for a policy pivot, and the longer Japan holds off on this shift, the more urgent we think it will become. Timing this move is difficult, but we believe it could happen at any of the next three policy meetings. So, we see the yen as a longer-term but high-potential outperformer.

The antipodean currency has held up well considering its long-standing sensitivity to global risk, the spread between short-dated US and Australian government bonds, and commodity prices. That said, we think it will find underlying support against the US dollar from Australia’s trade surpluses, thanks in part to China’s recovery. We see the current market expectation of a 25-basis-point cut to the Australian cash rate in July as inconsistent with record-low unemployment and elevated inflation. We therefore maintain our AUDUSD target of 0.72 by midyear.