The past four weeks have been about stabilization in the financial markets. U.S. nominal yields, which had been a key investor focus due to their explosive move higher in February, have lost momentum since the middle of March. Notably, U.S. real yields have also been stable since late February. This stability in real yields, plus strong PMI numbers and activity measures, has reinforced the expectation for strong global growth and thus led to positive market risk sentiment.
In the foreign exchange markets, this resulted in bifurcated U.S. dollar performance. In the G-10, the U.S. dollar has strengthened against most developed market currencies as interest rate divergence remains the dominant driver and yield spreads move in favor of the dollar. In emerging markets (EM), the stability in real yields has allowed commodity currencies sensitive to global growth to be more resilient to dollar strength. This nets out to dispersion in EM returns against the dollar being at post-COVID-19 highs while G-10 dispersion sits near a five-year low.
Looking ahead, the outlook for foreign exchange markets and the broad U.S. dollar remains unchanged. This view is informed by the following two factors.
First, the increase in developed market yields led by the U.S. should remain persistent due to the combination of historically large fiscal stimulus, strong growth momentum and rising inflation pressures. While the global growth outlook is improving, the U.S. is clearly leading the way, and this has justified widening U.S. yield spreads. It should, however, be noted that the path to infrastructure spending should be slower and more difficult relative to the path for COVID-19 relief. Nevertheless, infrastructure spending is expected to pass and should be a net positive for U.S. growth and thus the dollar.
Second, growth momentum outside the U.S. remains highly positive, which should support high beta currencies. The strength of underlying global growth can be seen through recent PMI data that has come out at multiyear highs. Notably, underlying details also show positive signs for the services sector and employment. Finally, better global growth is positive for commodity prices, including oil, which, by extension, supports petro-linked currencies. Empirical evidence shows that commodity-linked currencies have been more resilient to rising U.S. yields as they benefit commodity prices rising due to the same reason as yields.
In essence, further U.S. dollar strength is expected, especially against currencies that have central banks expected to remain dovish (EUR, JPY, CHF) while currencies sensitive to global growth should be more resilient. | |
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