G10 FX Weekly: USD Is on a Tear, But It Is Too Soon to Fade

Summary 

• The US Dollar Index (DXY) trades at a six-month high, having risen for eight straight weeks.  
• This rise has momentum and will probably continue into Q4.  

• At some stage, we think the rally will be worth fading because it cannot continue indefinitely, and a correction is inevitable. 
• This will require patience. It is presently too early to go against the recent uptrend. 

Market Implications 

• We think there is material downside to come in GBP/USD (cable). Against the USD (and other G10 currencies), sterling is our favourite short.  We expect cable to revisit the year-to-date (YTD) low near 1.18 in Q4.  

• Although we think the EUR/USD fall will be worth fading at some stage in Q4, we expect EUR/USD to trade near its YTD low just below 1.05 in the coming weeks before stabilising.  
• USD/JPY is poised to trade above 150 and will also probably challenge the high of ~152 from last October. JPY bears, however, must consider intervention from Japanese officials to oppose the weakening yen.   

Introduction 

The dollar’s rally over the past eight weeks – the longest winning streak since 2014 – has taken the DXY to its highest level since early March. The move has been a slow grind higher – only one week, the first in the string of eight, saw a gain exceeding 1%. 

There is a completely reasonable tendency to fade such a long, drawn-out move. Yet we think the current USD rally vs G10 counterparts can persist in the coming weeks so dislike selling into it at least until Q4.   

There are several reasons. The US economy is outperforming its developed market peers, with US yields higher than the vast bulk of others in the G10. These yield differentials, based on superior economic performance, will favour the greenback in the coming weeks. 

Additionally, the oil price has coincided with the surging USD, and we see room for further upside in oil.  

This means EUR/USD and GBP/USD can trade to their respective YTD lows and that USD/JPY also has further upside in the coming weeks.  

What Is Behind the Surging USD? 

While the summer period in the Northern hemisphere has been characterised by range-bound markets in FX, since about mid-July (when the DXY printed its YTD low) the greenback has appreciated a little over 5%. 

We now look more closely at the key drivers of this USD turnaround. 

US Economy Stands Out Among Peers 

Rather than slowing materially ahead of a long-forecast recession, the US economy remains robust, showing no signs of slowing. And, while this cannot last forever, for the coming weeks US economic outperformance can continue to buoy the greenback. 

A case in point is the contrasting PMI indices in the US, compared with Europe and the UK.  

The US August Composite PMI data, an amalgam of the services and manufacturing sectors, printed 50.2. While this is weaker than in Q2, the over-50 reading still points to expansion in the US economy. 

This starkly contrasts PMI data in Europe and the UK.  

In the Eurozone, the August Composite PMI reading came in at 46.7, implying contraction in the European economy. Moreover, both services and manufacturing readings came in below 50.  

It is a similar story in the UK. The August Composite PMI reading was 48.6, with services and manufacturing measures printing below 50. 

For FX, this contrast is notable and a big contributor to traders favouring the dollar over the euro and the pound over the past two months.  

Higher Oil Prices Favour Stronger USD 

Oil prices and the US dollar have risen concurrently over the past two to three months. This is no coincidence.  

Unlike the bulk of European countries and Japan, the US exports more oil and gas than it imports. As a result, higher oil prices benefit the US (and the dollar), dragging on energy importers in Europe and Japan.  

Higher oil prices, therefore, have weighed on the EUR/USD and supported USD/JPY. 

We think oil prices will continue to rise and should therefore push the USD higher. My Macro Hive colleague Viresh Kanabar expects further upside in Brent. Currently trading just over $92 per barrel, Viresh thinks it could reach $95. Viresh sees Brent extending through this month to that price level, although upside is potentially limited next month and beyond.  

Into Q4, therefore, the USD should receive further support from higher oil prices in the coming weeks. 

Higher US Yields Favour the USD 

Yields have risen across all the developed market yield curves after the concerted tightening cycles from most G10 central banks. However, US yields stand out among the highest. 

In the short end of the curves, US yields are considerably higher than those in Europe and Japan. The US 2-year yield trades at just under 5%, while the corresponding German yield is at 3.17%, with Japan at 0.03%. 

In the 10-year maturities, the US is at 4.25%, Germany is at 2.65%, and Japan is at 0.71% 

And, while UK yields are at similar levels to the US (2-year at 4.99%, 10-year at 4.35%), those yields are 59bp and 40bp off their recent highs seen this summer. By contrast, US yields have been steady or higher over the same period. 

All this means the USD has had favourable yield differentials, which has supported dollar longs. This positive carry will continue and should keep supporting the USD. 

A Look at Three Key USD Pairs 

The three most heavily traded G10 USD pairs are EUR/USD, GBP/USD and USD/JPY. We look at each of these pairs below. 

GBP/USD (Cable) 

We have been bearish sterling for the past six months. While the position has at times been frustrating and required patience, we think the recent sell-off in GBP/USD can continue. 

The pound remains our favoured short in the G10 space.  

So far this year, cable has traded in a ~1.18/1.3150 range. Since peaking in mid-July, the pound has declined about 5% versus the US dollar.  

We think GBP is set for a period of underperformance into yearend given the deteriorating UK economy.  

As my colleague Henry Occleston noted in his reaction piece to this week’s UK jobs data, the labour market has continued loosening, with the trend accelerating in the latest employment figures. 

Beyond the official data, the trend of a softer job market is also evident in survey data.  

The Recruitment and Employment Confederation’s measure of permanent staff placements dropped for an 11^th straight month, with the most recent reading registering the steepest fall since June 2020 during the pandemic. 

The slowing economy and still-elevated inflation have observers increasingly talking about UK stagflation, something we have been concerned about for several months. 

All-in-all, these economic challenges facing the UK will limit the BoE’s ability to tighten policy. Already, we have seen über-hawkish BoE market expectations soften materially in recent weeks. 

As such, we think the currency will soften into yearend. And, given the potential for further near-term USD outperformance, GBP/USD can gather downside momentum and trade near its YTD low of ~1.18. 

EUR/USD 

Like cable, EUR/USD has also softened considerably since mid-July, with the pair also tumbling about 5%. 

We had been bullish EUR/USD for about six months and saw the pair rise from ~1.05 to ~1.13, which defines its YTD range.  

In recent weeks, stagflation fears have also increasingly become part of the Eurozone economic dialogue, contributing to the euro softening. 

The marked slowdown in the German economy has been evident for several months, and this week the European Commission cut its outlook for the Eurozone economy, saying economic contraction in Germany will drag it down. 

Given these dynamics, we think EUR/USD can keep falling in the coming weeks, revisiting its YTD low below 1.05. 

The ECB rate decision today is a material near-term risk: a hike may immediately boost the euro. That said, as we predicted in our piece last week, the probability of an ECB rate rise has surged this week, diminishing the surprise factor.  

At the close of business on 4 September, when we published that piece, the probability of a 25bp ECB rate rise was about one in four. At the close of business yesterday, that probability was roughly two in three. 

In the 10 days or so since rate hike expectations have firmed, EUR/USD is lower, currently trading at 1.0744 versus 1.0796 at the close on 4 September.  

This tells us the downward pressure on the pair is material and gives us further conviction of our near-term bearish outlook.  

Moreover, should there be any bounce in EUR/USD on an ECB rate hike, we would view this as a selling opportunity and would fade any EUR/USD strength.  

USD/JPY 

USD/JPY has been largely one-way traffic this year since, printing its YTD low in mid-January at ~127. While there have been material pullbacks since then, the pair has risen considerably in the first three quarters of 2023, currently trading near its YTD intraday high of ~147.87.  

And, while stagflation is not imminent in Japan as in Europe and the UK, growth remains a concern for Japanese policymakers. Notably, the downward revision to 2Q GDP (from 6% to 4.8%) shows the fragility of the Japanese recovery. 

And, as we outlined above, US yields are considerably higher than Japanese yields across all maturities. 

We therefore conclude continuing USD strength will lift USD/JPY to a new YTD high.  

Beyond this, however, the threat of FX intervention from the Japanese authorities may cap gains as the pair edges closer to 150. 

Already, last weekend saw BoJ Governor Kazuo Ueda hinting at tighter monetary policy, a move many considered verbal intervention to stem the recent yen slide. 

The last actual Japanese FX intervention was roughly one year ago, when USD/JPY was trading around 150. After the Japanese government bought yen near that level, with USD/JPY peaking at ~152, the pair fell to 140 in the next month.  

As USD/JPY approaches 150, traders will be wary of history repeating itself. 

While the BoJ will probably leave its monetary policy unchanged later this month, the threat of intervention will probably limit the upside in USD/JPY. 

We therefore advise caution for USD/JPY longs.  

Richard Jones writes about FX and rates markets for Macro Hive. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side.

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