U.S. dollar strength likely to persist
The Fed has responded to stronger inflation and higher inflation expectations with increased hawkishness and has exhibited considerable resolve in its willingness to bring inflation back to target. Meanwhile, Fed officials continue to highlight that a recession does not need to happen to achieve this goal. The market continues to try to balance these risks. Considerable rate hikes are priced in for the next nine months before rate cuts are expected to dominate. Given the Fed's moves in the past months, room for more hawkish innovations seems ever more limited. That in and of itself is not a thesis for a weaker U.S. dollar. Weakness would require a marked move lower in inflation that would in turn require less tightening. While this is possible, it seems unlikely to happen in the next several months. As such, the performance of the dollar will continue to depend on U.S. inflation outcomes and prospects for global growth and risk appetite.
Rate hikes to bolster euro as energy prices remain relevant
The ECB has pivoted into a materially hawkish stance, with liftoff to begin in July and expectations for hikes of 50 bps at subsequent meetings. The bank also strengthened its pledge to avoid fragmentation risk by containing spreads on bonds of peripheral markets with the creation of a new instrument. The exact details are to be determined, but they will be key for longer-term valuation. The fact that such an instrument is in consideration should be a supportive factor for the single currency. The implications for energy prices and the consumption hit from the Russian invasion of Ukraine continue, as do concerns about a global growth slowdown driven by China's zero-Covid policy, keeping the single currency soft. If these risks abate or signs emerge that they could, there will be considerable upside risks to the euro.
British pound weak on relative policy softness
The Bank of England raised interest rates by 25 bps again in June and was more hawkish than in its May meeting by acknowledging it could act more "forcefully." But its forecasts are still below market expectations, and its shift remains significantly behind the more hawkish innovations from other central banks like the Fed or ECB. It's likely that this will keep the pound weak over the coming quarter, but the risk/reward of this outlook, given its underperformance, has deteriorated.
Yen weaker as policy diverges
The Bank of Japan (BoJ) continues to diverge from other global central banks and has been buying Japanese government bonds at an unprecedented pace to defend yield curve control. So, in the near term, the dollar-yen pair will be driven primarily by external factors as global central banks lift short-term rates to counter rising inflation and increasing hedging costs for Japanese investors. This puts downward pressure on the yen, but valuation will likely remain a headwind. The currency will likely stabilize and begin strengthening when the Fed's hawkishness has peaked, the BoJ pivots from its ultra-easy stance, or late-cycle dynamics come to fruition and recession risk becomes reality.
More from Fixed Income Outlook
Although central bank efforts to fight inflation could end in recession, we are constructive on some areas of fixed income.