In addition to the rebound in US macroeconomic data, we believe the new dollar strength is driven by the increased probability of a Trump victory in the US elections. We expect US rates to continue to be the main driver of yield spreads, meaning that developments around the election will continue to be at the forefront. Given that Trump’s potential policy mix will likely be more inflationary than that of a Harris administration, the Fed’s rate cut path would likely be less pronounced in the event of a Trump victory, suggesting that it is unlikely that dollar strength will soon fade in this scenario. A Democratic sweep would likely weigh more on the dollar after Election Day, while currency volatility should increase in a contested election scenario.
The US dollar has strengthened considerably in the first half of October. To a large extent, the currency’s strength reflects better-than-expected macroeconomic data. Several labor market indicators have improved, as has activity in the service sector. This has led to a considerable repricing of US rate expectations, with markets pulling back on more than one rate cut until the end of this year. However, while the dollar’s new strength can be attributed to these fundamental factors, it also largely depends on the final outcome of the US elections.
The policy mix of a Trump administration is likely to be more inflationary than that of a Harris administration. In particular, Trump’s tougher stance on immigration and the possible imposition of new tariffs point to increased price pressures under a Trump 2.0 and, therefore, they advocate a more superficial path of rate cuts. In our view, the increased likelihood of a Trump victory has likely raised US rate expectations above what recent macroeconomic data would suggest and therefore largely explains the magnitude of the recent revaluation in the currency market.
Looking at the dollar’s performance so far this year, much of its newfound strength can be attributed to recent weakness in the Japanese yen and euro, which have plummeted due to widening yield spreads.
Eurozone activity indicators have remained fairly subdued, suggesting that the ECB will continue to cut at its upcoming meetings. Growth prospects are unlikely to change substantially, given weak business and consumer confidence in France and Germany, which together form the backbone of the eurozone economyto. Consequently, we do not expect euro interest rate expectations to lift the currency in the near term.
Likewise, the Japanese economy has held up surprisingly well, and economic growth is increasingly likely to remain strong next year. With recent polls suggesting the Liberal Democratic Party (LDP) is likely to regain its majority in the October 27 general election, Prime Minister Ishiba aims to draw up a “large-scale supplementary budget” that would shell out money to ease the cost of living. at the end of this year. Certainly, the size of the package is still somewhat uncertain, but it should allow the BoJ to rise more than what the market is currently quoting. Consequently, it should also hit the longer end of the JGB yield curve and support the yen at the margin.
Given that we expect only minor adjustments to European and Japanese rate expectations, we expect US rates to remain the main driver of yield differentials and therefore We believe that the US elections will dominate currency dynamics in the short term. In our view, a Democrat victory would likely trigger the most significant (downward) readjustment of rate expectations, pushing the dollar significantly lower after the election. Betting markets currently suggest a probability of around 15% for this scenario. If this were to materialize, the yen would outperform other G10 currencies. We expect a lesser reaction from currencies in the short term in the event of a Republican sweepwhich we believe has more important long-term implications. After all, the likelihood of a contested election remains considerable, given the large number of electoral disputes. In this scenario, Currency volatility will increase until the courts clarify the final election result.
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