In the near term, the USD should remain supported by the relative outperformance of the US economy that will allow the Fed to normalize policy more quickly. The USD should further benefit from its role as a liquid safe-haven currency during recurrent bouts of risk aversion. In the medium term, expect the US economic outperformance to become less pronounced and the Fed to embark on gradual policy normalization. This, coupled with central bank tightening outside of the US, could encourage diversification flows out of the USD, especially given lingering concerns about the US twin deficits and the USD’s overvaluation. Observe the foreign exchange rates.
CAD - Canadian Dollar
The boost to Canada’s terms of trade has more than offset the market jitters stemming from the Ukraine-Russia war. The energy markets risk being durably impacted, and higher prices could subsequently linger for longer. Besides, the BoC is off to an earlier and faster tightening start than the Fed in H122. Some gradual CAD outperformance could resume over the USD, while a significant cooling on the geopolitical front may be needed for CAD gains to become more entrenched. Observe the USD/CAD trends.
EUR - Euro
The escalating Ukrainian crisis may fan the stagflation headwinds battering the Eurozone. The EUR's relative rate disadvantage as well as the persistent geopolitical and economic risks can discourage foreign investors from returning to European capital markets for the foreseeable future while further worsening of the Eurozone external imbalances can reduce net demand for EUR by corporates. That said, we believe the geopolitical risks will delay rather than derail the economic recovery, keeping the ECB on the path of policy normalisation in the coming months.
GBP - British Pound
Soaring energy costs, labour market shortages, global supply chain disruptions and persistent Brexit uncertainty continue to plague the UK economic recovery and hinder any BoE policy normalization in the face of uncomfortably high inflation. The currency could further be vulnerable to spikes of risk aversion. In the longer term, the undervalued GBP may recover as UK growth hurdles disappear and this allows the BoE to hike rates.
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