The USD is stuck at the bottom of the so-called ‘dollar smile’, which links its path to the performance of the US and global economy as well as the risk sentiment of investors.
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At present, sentiment is supported by the dovish stance of the Fed, which is also the primary reason for USD underperformance. The ‘dollar smile’ further postulates that the currency should appreciate from here – either because risk-aversion returns as investors realise the limitations of the ‘Yellen put’ or because of a sustained improvement in global growth and risk sentiment, which allows the Fed to resume its tightening cycle.
In the absence of a sustained pick-up in the global economy, we believe that the former outcome is more likely. We therefore expect USD to appreciate again against G10 commodity currencies as investors start questioning the Fed's ability to fall further behind the curve and the sustainability of the commodity-price rally in the presence of persistent downside risks to the global recovery. EUR and JPY should also remain more resilient against this background.
On a tactical basis, we stick with our view that a lot of negatives are in the price of USD so the currency will continue to respond more strongly to potential positive data surprises from here. Next week, investors will focus closely on US retail sales. Absent of any significant disappointment, the USD could extend its cautious recovery.
Among the key events next week will be the BoE’s May inflation report. Investors will want to know whether the MPC sees the latest economic slowdown as temporary, driven by Brexit fears, or persistent and thus likely to affect the policy outlook. With the EU referendum approaching, the MPC should stress the asymmetric risks to the outlook. This coupled with more evidence that the support for Brexit remains unabated should keep GBP on the defensive across the board.
Elsewhere, the Norges Bank should keep rates unchanged but they could cut its conditional rate path and keep the cyclical headwinds in place of NOK. In addition, potential positive surprises from Swedish inflation next week could burnish the appeal of SEK once again.