While CIO expects the US currency to remain strong in the near term, they think it will eventually weaken as the Fed's rate cuts approach. (UBS)

Fed funds futures markets are only pricing in 90 basis points of cuts, down from as much as 170bps at the peak in January. Since the start of the year, the greenback has strengthened over 3.3%.


But while we expect the US currency to remain strong in the near term, we think it will eventually weaken as the Fed's rate cuts approach. The posture of several other major central banks underpins this view and our favored foreign exchange strategies.


The Bank of Japan’s incremental steps toward policy normalization should support a recovery in the yen (JPY). The strength in the dollar pushed USDJPY back above 150, prompting Japan’s Vice Finance Minister for International Affairs and top currency official Masato Kanda to comment that authorities stand ready to step in. While verbal interventions historically have not generally led to concrete actions, and Japan's fourth-quarter GDP growth underwhelmed expectations, we think the BoJ's policy normalization remains on track this year on strong wage hike negotiations and corporate profitability. We maintain the view that the Japanese yen has likely reached a turning point after significant underperformance between 2021 and 2023.


With the US-Japan 10-year yield differentials expected to narrow as the year progresses, we think the current entry point to buy the yen is attractive. We also think a long yen position can serve as a potential risk-off hedge against certain macroeconomic risks, such as renewed worries of US-China trade tensions, or the risk of a larger-than-expected Chinese yuan (CNY) depreciation arising from China's challenging growth backdrop. To position, we like to go outright long yen versus low-yielding currencies such as the Taiwan dollar (TWD) or the CNY, or to sell downside risks in the yen for yield pickup against a range of reference currencies such as the Swiss franc (CHF), the euro (EUR), the British pound (GBP), the US dollar, the CNY, and the Singapore dollar (SGD).


Australia’s central bank has not yet made a dovish pivot. While the Reserve Bank of Australia (RBA) kept the cash rate on hold earlier this month, it reiterated that “a further increase in interest rates cannot be ruled out.” We still believe that the RBA will be one of the last major central banks to cut interest rates, with Governor Michelle Bullock downplaying the surprise below-expectation reading of inflation in the fourth quarter of last year. In our view, her comments implied that inflation would need to undershoot the central bank’s lowered forecasts before cuts would be considered. We continue to like the Australian dollar and believe that selling downside risks in the currency is an appealing strategy from a spot risk and volatility perspective.


The European Central Bank remains reluctant to declare victory in the fight against inflation. While the disinflation process may be unfolding more quickly than anticipated, ECB Chief Economist Philip Lane said last week that policymakers need more assurance that inflation is returning to its target, and that he prefers not to rush policy easing. Persistent price pressures in services and another round of a wage-price spiral remain concerning for several members of the ECB directorate, so we think the central bank is in no hurry to cut interest rates at this point. This should ensure the euro stays largely range-bound even amid subdued economic sentiment, limiting the potential for gains in the DXY index.


So, we continue to expect range-bound trading in the US dollar in the near term. We favor the Australian dollar, as well as the Japanese yen. We also like yield pickup strategies as opposed to outright directional positions in the euro, the British pound, and the Swiss franc against the greenback.


Main contributors – Solita Marcelli, Mark Haefele, Daisy Tseng, Thomas Flury, Jennifer Stahmer


Read the original report : Near-term US dollar strength likely to fade, 15 February 2024.