Fixed Income Outlook  |  Q3 2023

Currency views

Putnam Fixed Income team

Currency views

Dollar may waver

The dollar's course is likely to be shaped by U.S. Federal Reserve decisions, as well as risk appetite and how that impacts U.S. investors' allocating capital abroad. The Fed's rhetoric suggests it is likely not done with rate increases. The market has pushed out rate cuts to 2024, acquiescing to the fact that inflation continues to come down slower than hoped and the labor market remains tight. This makes a decisively hawkish pivot from the Fed hard to imagine. Risky assets globally have rallied considerably from the lows of 2022, but over the coming months, global optimism is likely to be challenged and more-cyclical currencies should underperform the dollar. From a longer-term perspective, we believe we have seen the highs in the U.S. dollar, and meaningful rallies will be opportunities to sell the greenback.

Euro may be attractive

The European Central Bank (ECB) has continued to raise rates and remains adamant that it has more to do about inflation, which has peaked but is not falling as quickly as desired while the labor market remains tight. The global growth backdrop should be less favorable as market optimism has shifted to pessimism about China, the eurozone's largest export destination. At the same time, it is important to note that China's monetary and fiscal authorities remain ready to provide support. This less favorable backdrop should create tradable ranges for the euro in the near term, but we believe meaningful dips will be opportunities to buy.

Pound sterling under inflation cloud

Faced with inflation that has been consistently higher than expected, the Bank of England (BoE) hiked rates by 50 bps in June. Its rhetoric remains far less hawkish than market expectations. The market is looking for another 125 bps in hikes by the end of the year, but the BoE's reaction function remains a bit difficult to ascertain, and the pound sterling may be subject to disappointment. The BoE's August meeting has considerable risks, as it will provide updated economic forecasts and has the potential to clarify policymakers' reaction function relative to those new forecasts. While sterling continues to remain cheap to its longer-term valuation, a more neutral stance seems prudent, given risks.

Yen may benefit from gradual policy shift

The Bank of Japan (BoJ) had been the policy outlier for some time. While it has begun policy normalization, its track record suggests the process is likely to be quite elongated. It's probable that its yield curve control program will eventually be dropped, but it's more likely that the BoJ will widen the band for rates in the coming months, providing some modest support to the yen. While local rates are important for the yen, the level of rates in the U.S. and the rest of the world plays a larger role, as they impact the cost of hedging and the flow of capital. The cost of hedging (and the expected cost) has widened out, and USD/JPY has traded higher in tandem. This weakening in the yen has been met with official comments about excessive moves in the currency, like those that predated intervention in September 2022. With stickier inflation and stronger data in the U.S. being better priced in, rallies in the dollar-yen exchange rate are opportunities to sell the dollar, we believe, due to eventual Fed/BoJ policy reconvergence.


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