THERE ARE STILL SOLID GROUNDS TO EXPECT THE USD TO WEAKEN A LITTLE FURTHER – SCOTIABANK

The peak in the Fed rate cycle appears closer. Economists at Scotiabank analyze what happens when the US rate cycle peaks.

USD is liable to slide to the low point of the “USD smile”

Broader pressure on the USD is likely to develop as cyclical headwinds mount and markets begin to anticipate easier Fed policy settings. Fed rate cuts are unlikely before Q2 next year but we forecast relatively rapid (compared to the ECB) rate cuts thereafter. 

The potential for more relaxed US monetary policy settings should be supportive for risk assets – a key factor in our broad outlook for further USD retrenchment. In other words, the USD is liable to slide to the low point of the ‘USD smile’ as US yield and growth premiums weaken and investors are encouraged to shift assets away from the USD to riskier, but perhaps higher-yielding investments.

On average the DXY falls nearly 5% in the first six to seven months after the last Fed hike and is down nearly 3% on average a year after the last tightening. Equity markets typically react positively to the Fed rate cycle peak, rising some 12% in the first year after the last rate increase (S&P 500).

We anticipate a moderate decline in the USD broadly in H2. Current trends, which reflect the DXY tracking index-weighted, short term spreads very closely, indicate that less supportive yield spreads (real or anticipated) will have to be part of the softer Dollar story in the coming months.