Dollar continues to dominate
Although the Fed’s rate-hiking cycle is coming to an end, monetary tightening through balance sheet reduction will continue. Among major economies, the U.S. now has the highest policy rate and pace of growth. Given that China is dealing with its structural issues, and Europe remains weak due to its energy transition and exposure to China’s weakness, U.S. outperformance is set to continue. This dynamic is likely to dominate in the near to medium term, strengthening the dollar further, in our view.
Euro hurt by weaker activity
The European Central Bank (ECB) raised rates in September by 25 bps and signaled the end of the hiking cycle. The ECB’s key policy rates are below the Fed’s, while the euro area growth rate is fluctuating around zero, well below U.S. growth. The European production model — and Germany’s model, in particular — has been changing, as cheap energy and labor along with strong Chinese demand are no longer available. This backdrop is likely to further weaken the euro, although the currency might occasionally benefit from rising optimism for global growth and stabilization in government bond markets.
Pound sterling carries less downside risk
The Bank of England (BoE) left its policy rate unchanged in September for the first time in two years. The meeting statement mentioned signs of loosening in the labor market and weaker-than-expected inflation in August. However, inflation remains uncomfortably high, and the BoE is likely to maintain high interest rates for longer, even though economic activity has little momentum. The pound sterling might gain some strength against the euro if government bond markets and, hence, risk appetite stabilize, but it might weaken a bit against the dollar.
Yen weakened by policy caution
The interest-rate difference between Japan and the rest of the world has materially weakened the yen. The Bank of Japan (BoJ) is significantly behind in tightening policy, and domestic inflationary pressures have risen. The “higher for longer” interest-rate environment in major economies is likely to accelerate the BoJ’s exit from the yield curve control and negative interest-rate policies. Until the eventual exit from these policies, the yen is likely to remain under depreciation pressure.
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