U.S. dollar may come under downward pressure
The United States is set to see its twin deficits widen amid rising fiscal spending and a consumer boom. Deficits have been an indicator of dollar direction over past cycles because these deficits need to be funded or the dollar needs to fall. With front-end rates pinned close to zero, flows into U.S. fixed-income markets are likely to be hedged, leaving the dollar in need of unhedged flows into equities or via inbound mergers and acquisitions. The Fed remains sidelined for now, but the market has priced in earlier hikes and may continue to do so, which should be supportive of the dollar. The global recovery has lagged the United States but should accelerate in the latter half of the year, and investors may look for better opportunities outside the United States, eventually putting downward pressure on the dollar.
Euro to trend moderately higher
Europe is experiencing continued weakness in the near term as lockdowns and poorly managed vaccine rollouts delay its recovery. The ECB has voiced concern over the slowing economy and has increased asset purchases accordingly. This has resulted in euro area rates lagging the move up in global rates and in a weaker euro. It is likely the move to front load bond purchases was a trade-off at the expense of more buying later, suggesting peak dovishness from the ECB. The euro's valuation has improved as the U.S. dollar strengthened, and valuations could improve further over the short run. But we expect the euro to trend moderately higher against the dollar as European conditions improve (local lockdowns ease and vaccinations accelerate) amid a global economic recovery.
Upside for British pound over the medium term
Amid a virus resurgence, continued lockdowns, and potential trade frictions with the European Union, we have seen some short-term economic pain. However, the United Kingdom remains positioned well for a domestic and global recovery, fueled by one of the better-run vaccination campaigns. There will be near-term risks and medium-term upside for sterling.
Japan's yen is likely to appreciate
The Bank of Japan (BoJ) remains largely sidelined, with limits on further monetary policy easing. In March, the BoJ tweaked the guidance around ETF purchases and allowed more flexibility in bond yields. The yield on the 10-year Japanese government bond (JGB) will be allowed to fluctuate +/- 25 basis points in each direction around its 0% target. The new band will provide room for temporary deviations while ensuring bond yields remain low (in absolute terms and relative to other markets). The yen has already seen a large repricing on the back of the global recovery and could grind weaker as it progresses. Still, yen strength on risk shocks is likely to be more pronounced going forward.