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FX: The rate cut race shifts into high gear
Quarterly Outlook
Summary: 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.
US exceptionalism set to fade
US economic data has been strong in the first quarter, but signs of weakness are emerging, potentially marking a turning point for the US economy. The ISM manufacturing survey fell to 47.7 in February from 49.1, while ISM services also eased to 52.6 from 53.4. Both employment gauges are now contracting and the February NFP report also showed higher unemployment rates and receding wage growth despite strong job growth. Indicators such as consumer confidence, retail sales, JOLTS job openings, and University of Michigan sentiment survey have all surprised to the downside recently. This suggests a shift away from US economic exceptionalism in Q2, aided by European stability from lower natural gas prices due to another mild winter, and China’s recovery as policy loosening measures over the last year start to seep in.
Soft landing, however, still remains the base case despite US exceptionalism starting to fade. The dollar smile theory suggests that soft landing could bring a weaker dollar, and it may be prudent to reassess long dollar exposures. However, there are concerns about the durability of dollar weakness, as new risks loom on the horizon. The impending US elections and the possibility of a Trump 2.0 could potentially lead to a strengthening of the dollar due to tariff risks and safe-haven flows.
Competitive pivot bets to drive FX markets
Markets now expect the Fed to start cutting rates in June or July. This has begged the question whether some of the other central banks, particularly the ECB, can hold rates higher for that long or risk a hard landing. This suggests that the competitive pivot story will keep driving the FX markets in Q2.
Speculative long positioning in EUR has been cut to half from December highs, and there seems to be a lack of catalysts to drive the next move lower for now. At this point it appears that the Eurozone economy is stabilising with natural gas prices turning lower. On the contrary, GBP longs are at multi-year highs and clear signs of disinflation in Q2 could prompt increased pricing of Bank of England’s rate cuts. This will bring scope for EURGBP to drift higher.
Meanwhile, AUD stands to benefit with the Reserve Bank of Australia expected to lag both the Fed and ECB in timing and magnitude of rate cuts. China's economic slack may also be mitigated by policy loosening efforts. In addition, broad USD weakness in Q2 will mean a recovery in high-beta activity currencies, unless there is a risk-off shock to the global economy.
Yen faces risk of a carry unwind
Signals of strong wage growth prompted the BOJ to pivot away from negative rates in March, embarking on a new era, despite maintaining a broadly accommodative policy.
This, along with potentially lower yields and a weaker dollar in the second quarter, has led to the possibility of yen appreciation and the unwinding of carry trades. As Brent Donnelley wrote in "The Art of Currency Trading", carry trades go up the escalator and down the elevator.
Still, we expect the BOJ to underwhelm on normalisation expectations, which will keep the sentiment on yen only modestly positive and primarily driven by the US side. This might not be sufficient to offset the negative carry of a short USDJPY position, suggesting a preference for tactical positions or options play. However, it may be worth considering a neutralisation or tactical reduction of the FX hedge on any exposure to Japanese equities. In the FX realm, yen crosses with minimal carry bleed, such as CHFJPY or CNHJPY, could be worth considering.