FX Outlook: USD in limbo amid political and policy jitters

Harris’s status quo will leave the Fed in the driving seat

A Harris presidency would likely emphasize fiscal restraint, with tax hikes playing a key role. This shift could prompt a more accommodative monetary policy from the Federal Reserve, increasing the likelihood of deeper interest rate cuts. The combination of fiscal tightening and monetary easing could be a near-term headwind for the USD. However, the probability of Harris securing a clean sweep remains low. A divided Congress could lead to policy gridlock, hindering significant fiscal initiatives and increasing market volatility. This environment might boost demand for safe-haven assets, such as the USD, Japanese yen (JPY), and Swiss franc (CHF), especially if current stimulus measures face uncertainty in renewals and concerns about a 2025 recession grow.

Harris’ victory might also avoid a drastic worsening of trade relations, which could initially boost the Chinese yuan (CNH) and other emerging market currencies, in turn weakening the USD amid a risk-on environment. However, China’s economic challenges may limit CNH gains. Similarly, commodity-exporting nations such as Australia and New Zealand could see their currencies rally as risks of worsening global trade relations are priced out. However, medium-term FX performance will largely depend on the broader economic context, whether the global economy achieves a soft landing or slips into a deeper recession.

Fed policy and risks of Yen carry trade reversal

With the Federal Reserve having begun its rate-cutting cycle, the USD is facing increased downside pressure. While the ‘Dollar Smile’ theory says that a soft-landing can mean a softer USD, it also needs other major economies to be relatively stronger to attract inflows. However, the German and Canadian economies continue to face hard-landing risks and China’s growth engines could sputter further if global growth slows. This means Q4 could be bumpy for USD as the Fed cuts rates further, but a sustained sell-off may still be unlikely. Currency crosses like EURGBP (downside) or AUDCAD (upside) could remain interesting to watch on economic and policy divergences.

The Bank of Japan has left the door open for future rate hikes, narrowing the US-Japan yield differential and driving a reversal in the dollar-yen carry trade, with the pair already pulling back significantly from summer highs. As we approach the end of 2024, further unwinding of carry trade positions could support more yen strength. However, the pace may slow as the Fed could struggle to meet the market’s dovish expectations if a recession doesn’t materialize quickly. Meanwhile, the BOJ’s cautious stance, with fading yen weakness reducing price pressures, may also moderate yen gains. The case for yen strength remains, bolstered by its safe-haven appeal and the shrinking yield gap with the US, but both the Fed and BOJ are likely to move gradually, keeping yen gains more modest.