Fixed Income Outlook  |  Q2 2018

Currency views

Fixed Income Team

Currency views

Shifting outlook for dollar

The outlook for the U.S. dollar has shifted. The drivers now include structural factors as well as the cyclical aspects of Fed policy and the newly minted tax reform, which we believe should provide some mild positives for growth and have limited impact on an already benign trajectory for rising inflation. The Fed delivered a rate hike in March, and new Chair Powell cautioned not to put too much weight on the dot plot projection given that it is conditional on economic forecasts that are liable to revision. Concerns that the Powell-led Fed will have a more hawkish reaction function were misplaced. We believe the U.S. dollar will be influenced by the Fed, but also by valuation, which is still rich, and by the twin deficits: the current account and budget. Both of these deficits are set to start widening and will require greater levels of capital to fill the gap. Over the coming months, U.S. dollar rallies are likely to be sold, in our view.

The euro appears stable

The outlook for the euro remains dominated by relative monetary policy, robust growth, and diminished political risk premium. The European Central Bank has been leaning dovish as growth has come off the boil and core inflation remains benign. Inflation should start to increase in the coming months, with headline inflation rising before core. Growth should stabilize at lower levels, while still strong. The euro has already moved considerably, but little is priced for the ECB, so much of the near-term direction will be based on how dovish or hawkish the ECB actually is relative to the Fed.

Hawkish Bank of England to influence pound

In the United Kingdom, political concerns have declined. The EU summit produced a transition agreement that will apply from March 2019 through 2020, and the probability of a soft Brexit continues to increase. The Bank of England has again surprised the markets by suggesting more hikes may be needed than are currently priced. With inflation high, monetary policy will look to lean hawkish and supportive of the currency.

Yen may gain against dollar

In Japan, with the re-appointment of Bank of Japan Governor Kuroda, continuation of ultra-accommodative monetary policy is set to continue in its current form. Governor Kuroda continues to underscore that the inflation outlook remains subdued, that prices are rising gradually, and that the economy is moving out of the deflationary situation. An immediate change to the yield curve control policy seems premature as inflation hasn't reached its objective, but a change is being considered and may be likely over the coming year. Structural forces will start to play in favor of the yen versus the dollar.

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Global growth prospects are expected to remain solid in 2018.