The US dollar's downside might be contained

The Federal Reserve played catch-up last week. It’s 50-bps rate cut was larger than the 25-bps norm that we’ve seen so far across those G10 countries that have eased. The big move appeared to be down to the fact that the Fed has started later than others rather than a sign that members fear that the economy is weakening too quickly. If this implies that the Fed will revert to 25-bps rate cuts going forward then the damage to the US dollar should be limit   ed, at least from the perspective of interest rate differentials, because it seems unlikely that these are going to diverge significantly, except for the yen, of course.

However, we have never viewed the risks to the US dollar from Fed easing as being down to rate differentials. Instead, the threat comes from the fact that Fed rate cuts ease global financial conditions and, in doing so, could create a significant rally in riskier assets while weighing on safe assets; one of which is the US dollar.

Unsurprisingly, last week’s large Fed rate cut has spurred risk assets, such as equities, but it hard to believe that major risk-asset rallies can take place ahead of such a pivotal US election on November 5th. Investors are likely to be guarded and this will limit    the scale of pre-election US dollar weakness. The euro, for instance, is closing in on the 1.1275 level that was the high from July 2023 but we’d be surprised if it can blast past this level and so pile more pressure on the dollar. After all, the euro zone economy looks as if it is entering another difficult period after the modest rebound seen in the first half of 2024.

In short, if any central bank needs to speed up rate cuts right now, it seems to be the ECB, not the Fed. In addition, the region has its own political question marks. France’s new government under PM Barnier could soon fall with a nonconfidence vote looming while, in Germany, keeping out the far-right AfD Party seems to be getting harder all the time despite the fact that it fell short of winning the regional election in Brandenburg over the weekend. In short, it is hard to envisage the euro really taking the fight to the US dollar.

The only currency to have done that so far is the yen, but this is predominantly due to carry-trade unwinding and less to do with optimism about the Japanese economy. Moreover, the signs are that carry trade unwinding may have run its course. Only time will tell, but yen gains against the dollar will be harder to achieve than those we’ve seen since dollar/yen peaked at near-162 in July.

Steve Barrow, Head of Standard Bank G10 Strategy, said of any G10 currency, it seems to be the pound that is really taking the fight to the dollar. It is up by around 4% so far this year and sterling has also made gains against all other G10 currencies as well. Part of this seems to be down to the change in government in July’s election. However, optimism over economic revival has been knocked back somewhat by Labour government warnings about a tough budget on October 30th while recent economic data has started to suggest that the economy is slowing again after the bright start to 2024.

Going forward, the outlook for sterling/US dollar could hinge on whether traders and investors reward the budget stringency shown by the UK government relative to the fiscal laxity that seems to be a feature of the US; something that could get worse should Republican candidate Trump win November’s election. In some instances, budgetary largesse can generate currency strength. We saw this when Trump won the 2016 election on a tax-cutting ticket. But much here depends on whether central banks react to looser fiscal policy with tighter monetary conditions, and that seems unlikely in the US as the Fed has started an easing cycle.

“There is also the issue of the size of the deficit and debt. For engaging in what might be seen as reckless fiscal expansion when the deficit and debt are small, as a proportion of GDP, for instance, is vastly different from undertaking the same policies when deficits and debts are large. With the US budget deficit already forecast at around 6% of GDP for some time, we fear that fiscal easing will hamper the US dollar, not help it. Hence, from a fiscal perspective alone we feel justified in thinking that sterling/US dollar will rise to the 1.40-1.45 range over the next year, or so,” said Steve Barrow.