The U.S. dollar outlook continues to be most heavily influenced by the Fed, as expectations for fiscal policy have been pushed beyond the investment horizon. The Fed hiked rates by 25 basis points at its June meeting, gave an outline for the mechanics of winding down the balance sheet, and chose to look through the recent softness in inflation data, describing its causes as temporary. This stance is relatively hawkish compared with market pricing and our own beliefs. With no urgency to hike rates aggressively, it is likely that the Fed will start to pare back the balance sheet gradually, but economic data and financial conditions will play a larger role in determining the pace, leaving the expensive dollar as more of the laggard than the leader among currencies.
The outlook for the euro is dominated by relative monetary policy and political risk. The ECB continues to balance the doves, who point to a tame core inflation rate, with the hawks, who call for removal of emergency-level accommodation and tapering of asset purchases. This balance is likely to persist until September or October, when the ECB will communicate to the market what it will do at year-end when the purchase program expires. Over the medium term, the euro should continue to appreciate.
In the United Kingdom, the results of the snap election have left the Conservative government in a much weaker position as they are forced to form a minority coalition with Northern Ireland's DUP (Democratic Unionist Party). The market has taken this to mean that the Conservatives will be forced to take a softer stance and remain in the single market and customs union, but in actuality, the likelihood of a hard Brexit has increased. In this context, the Bank of England kept rates unchanged, but three dissents in the vote suggest that its tolerance of inflation is limited. Since much of the recent U.K. inflation spike has been caused by currency weakness, it appears likely that the currency will not be allowed to fall much further. Given the risks associated with Brexit, the pound should be weak, but not excessively.
Bank of Japan (BoJ) Governor Kuroda continues to underscore that the inflation outlook remains subdued and, as such, the market should not expect any change in BoJ policy for the foreseeable future. This will keep the dollar-yen rate a function of Fed policy and the pace of policy relative to market pricing. Over the medium term, however, the return distribution is asymmetric because the yen is fundamentally cheap. A more dovish Fed stance could cause the yen to appreciate more swiftly.