BofA

EUR and USD 20-year reunion

We have been out-of-consensus USD bulls this year, but it now turns out we have not been bullish enough. EURUSD is back to parity after 20 years. USDJPY is at 139, the highest level since the East Asian financial crisis in the late 1990s. Cable at 1.18 has reached the lowest level since the early pandemic dip. The USD is by far the stronger G10 performer this year, with the JPY the weakest and EUR and GBP in the middle. The overheating US economy and the hawkish Fed have a lot to do with the strong USD. We have been expecting global inflation to be sticky on the way down, but it is still on the way up. US (and UK) headline and core inflation rates are the highest in G10. The US labor market remains very strong and very stretched. The Fed is downplaying recession risks and is focusing on fighting inflation. They were late to start hiking, based on the false belief last year that inflation was transitory, but they are now very determined. Most other G10 central banks have also turned hawkish.

The BoC surprised this week with the first central banks in G10 this year to hike by 100bp. In any case, 50bp has already become the new normal. However, currencies fail to rally after the hikes, partly because of the upward USD trend and partly because of risk-off. However, beyond the USD, relative monetary policies remain a key FX driver—CAD is the second best performer in G10 this year, after the USD. The BoJ remains the only in G10 that committed to loose policies. We expect the BoJ to deliver a one-off rates adjustment in 2H CY22 (base case October), consisting of a hike to the short rate target (to 0.0-0.1%) and a shift in the YCC 10yr target permissible trading band to +0.0-0.5%. But we think it is too early for the BoJ to capitulate and see no change to YCC next week. In our view, they are right to remain dovish, as core inflation remains well below 2%, while headline inflation at 2.5% is the lowest in G10. Still, given how much JPY has weakened, some verbal intervention next week is likely. This may prevent further JPY weakness, but is not enough for a turn, in our view.

As we have discussed in recent reports, the ECB stands out as the central bank with the lowest policy rate in G10 and the only one after the BoJ that has not hiked yet. We do expect them to start hiking next week, but by only 25bp, as Lagarde has repeatedly pre[1]announced. A 50bp hike would be more than justified in our view, given persistent inflation surprises, but unlikely and even counterproductive given recent communication. We have been arguing that the ECB is held back by periphery concerns. We may get some insights about how they will address fragmentation risks next week, but we believe it will take longer to come up with the new policy tool that the ECB has promised.

Our economists expect a light OMT (Outright Monetary Transactions) before September, with existing conditions (fiscal and Next Generation EU commitments) enough to pre-qualify. This avoids the program stigma and should allow the ECB to accelerate hiking this fall, but we are concerned that such a “fudge,” in addition to increasing negative supply shocks, will not be enough to allow the ECB to be as hawkish as most other central banks.