The Dollar Index (DXY) rose for a third consecutive week as the Federal Reserve looks set to hike rates by more than previously expected. The latest US data showed inflation is proving more persistent than anticipated and the jobs market remains too tight to keep wage growth in check. Since the beginning of February, the DXY has appreciated by 2.8%. The US 2-year Treasury yield has risen to 4.61% from 4.21% at end-January while Fed futures market pricing for the policy rate peak has increased to 5.3% from 4.81% at the start of this month, with the peak now not expected until August.
But although we think the latest US data suggest it is too early to expect a dovish pivot from the Fed, we do expect an inflection point in inflation, monetary policy, and market sentiment at some stage this year. Furthermore, we believe there are inflection points evolving in other regions that will also drive the currency markets.
We see tailwinds from commodities and yields lifting the AUD.
We remain most preferred on the Australian dollar despite recent volatility. The Reserve Bank of Australia Governor Philip Lowe reiterated on Friday he expects “further increases will be needed over the months ahead” as the central bank seeks to clamp down on inflation. Australia’s inflation data has surprised to the upside with 4Q22 headline and core trimmed-mean CPI accelerating to 8.4% and 6.9% y/y, respectively. With a terminal rate now likely above 4%, and the Fed eventually expected to cut before the RBA, we expect the discount between Aussie and US bond yields to narrow over time.
Moreover, we believe that Chinese demand for Australian commodities such as energy, industrial metals, agriculture, and livestock, will rise given China’s economy has reopened after a three-year hiatus. This, and the eroding USD yield advantage, should keep the AUD well-bid over the medium term. We target AUDUSD to climb to 0.72 by June and 0.76 by December.
We expect China’s reopening to support the CNY.
China’s economy is at an inflection point as the country exits three years of zero-COVID policies. The smoother-than-expected reopening has already lifted the manufacturing and services PMI data into expansionary territory in January while mobility data over the Lunar New Year holidays showed an encouraging recovery in travel and consumption.
As a result, net inflows into mainland Chinese trading exchanges reached USD 22bn last month. We expect China’s GDP to grow by 5% this year, up from 3% last year, led by a recovery in consumption. Despite the recent bounce in the USD, our bias for USDCNY remains skewed toward the downside, and we target the pair to slide to 6.6 by June and 6.5 by year-end.
The BoJ is nearing an inflection point as strong CPI data keeps policy normalization on track
Japanese CPI data for January due this week are likely to show headline and core inflation rising to multi-year highs of 4.3% and 3.2% respectively, well above the Bank of Japan’s target of 2%. We believe this is bringing the Bank of Japan closer to an inflection point after years of ultra-loose monetary policies.
While the BoJ has already tweaked its policy in December by lifting the cap on its 10-year government bond to 0.5% from 0.25% previously, we think the central bank is likely to scrap the yield-curve control program altogether sometime this year to curb inflation. We maintain our downside bias for USDJPY and we target the pair to decline to 122 by June and 120 by year-end.
GBP is likely to weaken as BoE is also close to an inflection point.
Unlike the Fed, we think the Bank of England is much closer to a dovish pivot after indicating that the February rate hike might be its last. Sterling fell to a 6-week low last week after UK data showed that inflation slowed to a 5-month low of 10.1% in January. We think the data, along with the BoE’s forecasts, suggest that further rate hikes are unlikely. But even if a further 25bps increase materializes in March, we don’t expect it to provide much tailwind to the GBP with leading indicators rolling over and weakness in the PMI data. We recommend going long EURGBP at the current spot price of 0.889, targeting 0.906 with a stop-loss of 0.876.
