U.S. dollar likely to rise as Fed mulls rate hike
The United States is set to see its twin deficits widen amid rising fiscal spending and consumer demand for goods and services. 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. As hedged ratios increase, it leaves the dollar in need of unhedged flows into equities or via inbound mergers and acquisitions. At the June meeting, the Fed unexpectedly pivoted to a more hawkish tone on its policy rate. Labor market data and future job gains will be pivotal for the Fed as it charts a plan for ending the easy money policies. This makes dollar appreciation against currencies backed by resolutely dovish central banks such as the yen, the Swiss franc, and, potentially, the euro, more likely.
Neutral outlook for the euro
European data continues to improve as lockdowns are eased and vaccine rollouts improve. The ECB in June said its PEPP will continue at a "significantly" higher pace and avoided a hawkish surprise. The central bank is in the process of finalizing its strategic review, which is expected to result in a 2% inflation target. Other big questions on the ECB's table include the future of the PEPP, which is currently set to last until March 2022, and whether to expand the asset purchase program. In the near term, improving growth should continue to be supportive of the euro. But over the longer term, the ECB's decisions could weigh on the currency, suggesting a more neutral outlook for the euro against the dollar. The euro is likely to act as a funding currency for better growth stories elsewhere.
British pound likely to trend higher
We believe the United Kingdom remains positioned well for a domestic and global recovery, fueled by one of the better-run vaccination campaigns. The Bank of England continues a glide path of less dovishness. But with the Coronavirus Job Retention Scheme (CJRS) set to end on September 30 this year, it is unlikely the central bank will offer any significant support for the currency. This will leave the pound's movements more reliant on global forces. We expect to see near-term risks and medium-term upside for the sterling.
Japan's yen likely to depreciate amid global recovery
The Bank of Japan (BoJ) remains largely sidelined with limits on further monetary policy easing. The yen had seen a large repricing on the back of the global recovery but has been range bound since peaking in April. From here, the currency is likely to grind weaker as the global recovery broadens. Yen strength during economic shocks is likely to be more pronounced going forward, in our view.
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Global financial markets were mixed during the second quarter.