One month since the Brexit referendum, the USD appears to be once again in the driver’s seat. However, the complexion of the FX markets has been somewhat different than anticipated, with risk sentiment proving resilient, and the combination of strong US corporate earnings and solid economic data has caught the markets by surprise. The interaction between Fed expectations and the global risk backdrop will be key for the direction of the USD in the coming weeks.
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The Fed effectively orchestrated a significant decline in real US rates between March and June, which helped fuel a recovery in risk sentiment and kept the USD weak (see chart below). This is starting to change to the benefit of the USD. We believe the FOMC next week will be reluctant to overcommit in July, but we are more optimistic than the market on the odds of further tightening this year. The biggest scope for an adjustment in rate expectations is probably for 2017–18, as the curve is extremely flat at the moment.
Central bank themes are becoming more prominent elsewhere in the G10. BoJ expectations are running high and we believe policymakers will struggle to live up to them, as our economist expects no further easing next week. Prospects for fiscal stimulus in Japan as well as a more positive US outlook still suggest USD/JPY dips are a buying opportunity.
The ECB made few changes to its policy stance. We do not anticipate another existential crisis for the EUR, but we still see it as a funding currency amid a sluggish economy and a dovish ECB.
We believe concerns over a particularly disruptive reversal of UK capital flows are overdone. That said, there are downside near-term risks for the GBP from the incoming data, including Q2 GDP next week.
Oil currencies NOK and CAD could be in double trouble vs USD amid higher US rates and weaker oil. Markets expect the Australian CPI release next week to cement the case for a rate cut in August. We think this is not a fait accompli and remain constructive on AUD/NZD.