Head of FX Strategy
Summary: Our latest economic outlook calls for a light stagflation in the US which could complicate the path of the central banks including the Fed. The US dollar has recovered recently on higher US yields and Fitch’s rating downgrade, and a clear downtrend in the greenback may have to wait until the Fed pivots.
Last week, SaxoStrats updated their US outlook call to Stagflation Light, which was explained in this article from our CIO Steen Jakobsen and here in this podcast from the Strats team.
While the US economy continues to hold up for now, the momentum is set to slow due to the lagged effects of Fed’s tightening. This change in economic outlook is underpinned by increasing credit risks, as well as expectations of weakening of the US consumer as pandemic-era savings get depleted and student loan forbearances come to an end. Meanwhile, disinflation trends could continue for now, driven by weakness in demand and some easing in supply chain pressures. However, we believe it is increasingly unlikely for inflation to reach the Fed’s 2% target amid the labor supply constraints, fragmenting global economy and green transformation. Still, we do not expect a stagflation scenario like in the 1970s or 1980s, so there is no reason to panic but there this is a “light” stagflation call which suggests there may be some downsides ahead for portfolios and diversification or protection strategies should likely be considered. We have discussed a range of these options in the following pieces:
In this article, we discuss what the Stagflation Light call could mean for the FX world. From a central bank’s standpoint, this is a complicated scenario as it gives them little room to respond to either growth or inflation pressures. Fed will likely have to keep interest rates higher for longer in this scenario, until the inflation or growth concerns become a bigger priority leading to a significant event. Most likely that would mean a credit event, in which case the Fed will have to turn back to rate cuts or accommodative policies either in late Q4 or early 2024.
While July proved to be a tough month for the dollar, it is becoming increasingly clear that the US disinflation story is perhaps not enough for a full breakdown of the greenback. Several drivers of US dollar strength since then have been:
For a full breakdown of the dollar to happen, we need to see a more stark deterioration in US activity and growth indicators which seems to be somewhat off. Other factors that could propel a dollar downturn could be a stronger recovery in Chinese or European economies or clearer Bank of Japan tightening move, both of which appear to be unlikely as of now.
This suggests there may be room for the dollar to sustain some momentum for now until clearer dollar bear trend starts later when the Fed pivots. FX ranges could remain narrow in the meantime.
As volatility remains muted, dollar carry trade still remains interesting. The most favoured funding currencies have been Japanese yen, Chinese yuan and the Taiwanese dollar. Bank of Japan’s policy tweak has not changed that and any major shifts in policy remain unlikely before the next wage negotiation results. Traders may be wary of BOJ intervention while USDJPY stays above 145, but the patience levels of Japanese authorities have likely increased.
Also, a durable dollar downtrend is hard to imagine with what’s going on in China. Economic data continues to weaken and the central bank has come in with modest policy cuts this week to provide support. Calls for more stimulus continue to escalate, but any measures so far have had little impact on confidence and demand which continue to be weak. Weakness in the Chinese economy, as well as any further easing measures, mean yuan could remain under pressure until a Chinese recovery is more evident.
The DXY index currently trades above 103, having recovered from the July lows of 99.58 and broken above the trendline resistance as show in the chart below. Key resistance ahead at 200DMA of 103.30, but if that is broken, there could be further upside to the 104 handle. There is also still room on the RSI for further upside, bringing caution to bears.
Our Stagflation call could mean a short-term uptrend in the US dollar, primarily on the back of carry funding currencies such as Japanese yen (JPY), Chinese yuan (CNH) or Taiwanese dollar (TWD). Yen however remains on an intervention watch. Emerging market central banks face the most complex setup in a stagflation scenario, and EM FX may suffer as a result. Other safe-haven currencies such as the Swiss Franc (CHF) could continue to be in favour along with the dollar while stagflation plays out.
Aussie dollar remains particularly exposed to the slowing Chinese economy and the property sector issues in China. Commodity prices will likely remain depressed in a strong dollar environment, suggesting little scope for AUD to recovery until a clear recovery in China or a certain end to the Fed’s tightening cycle. Some scope for an upside surprise in Australia’s inflation remains, and this could mean markets may have to reprice the path of the RBA. NZD also faces China risks but a less hawkish RBNZ means little room for recovery.
Tactically, there could some strength in sterling (GBP) as the Bank of England may need to hike more than what the markets are pricing in for now, but structurally GBP looks weak as the central bank will likely have to force a recession to get inflation under control.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
