FX Analysis: Stronger Dollar, Higher Volatility

While we’re bullish on the dollar over the medium term, there are some technical factors for why it could retrace some of its recent gains in Q1.

1)      Extreme positioning: Long US dollar positioning looks very stretched on several metrics, including futures positioning by hedge funds and asset managers, and elevated option risk-reversal skews. However, history shows that positioning can remain stretched for months (graph 6). Thus, we see the current overhang as a sign of overbought conditions, but not a fundamental catalyst for a reversal per se.

2)    Tighter Financial Conditions Index via yield differentials: The 10-year bond yield spread between the US and its trade-weighted basket has widened to about 120 basis points, which is a key resistance area (graph 7). The correlation between the US Dollar Index and this indicator is high, standing at about 70% over the past 12 months. If the bond yield differential continues to widen, the dollar may rise further. However, a very sharp tightening of financial conditions may lead to a slowdown in growth and eventually undermine the dollar.

More generally, an unresolved question for 2025 is how the US dollar would react to equity market turmoil. Muscle memory says it will be a haven. But there is nuance to this. Foreigners have been large buyers of US assets, particularly since the presidential election because investors now expect stronger growth. If US stock and bond prices fall due to inflation, perhaps the flows will reverse.

There are three long-term drivers of the USDCAD: the productivity gap, monetary policy divergence and commodity prices. The first two continue to point toward a weaker Canadian dollar, but the third could be more supportive, depending on the effectiveness of China’s stimulus measures.

Specifically:

• Productivity gap: Since the pandemic, Canada's productivity has fallen behind that of the US (graph 8). This means the Canadian dollar needs to depreciate to keep Canadian exports competitive. Unfortunately, Canada will continue to lag in productivity unless there are significant changes in government policies to encourage non-residential capital expenditures and reverse the brain drain External link..   

• Policy divergence: According to our factor decomposition model for USDCAD, front-end rate differentials have had the highest explanatory power over the last two years. The market is currently pricing terminal BoC rates at around 2.75% and Fed Funds around 3.75%. We think the market is under-estimating BoC cuts, so this spread may widen further, creating scope for a higher USDCAD (graph 9). Holding everything else constant, a 10-basis point widening of the 2-year spread is associated with a 30-basis point cheapening in the Canadian dollar.

• Commodity prices: The Canadian dollar, historically considered a "commodity currency," has become less sensitive to commodity prices, partly due to reduced mining and exploration capital expenditures. Our factor model suggests commodity prices have only a marginal impact on the currency once other factors like monetary policy, risk appetite and the US dollar are considered. Still, we suspect global factors like Chinese stimulus measures or geopolitical events could boost commodity prices in 2025, which may help mitigate the headwinds against the Canadian dollar.

While we forecast a weaker loonie in 2025, the long-term outlook could be bullish. The next government may adopt policies that promote investment in Canada's resource sector. Bringing more of Canada’s vast resources to international markets would increase demand for the Canadian dollar.

We will review our forecasts when there is more clarity on the next government’s economic agenda. 

We expect 2025 to be another challenging year for the eurozone economy. The manufacturing sector is struggling with high energy costs, competition from China and financial problems. US tariffs will only complicate matters futher. With subdued growth and ongoing disinflation, the ECB is facing mounting pressure to lower interest rates. We expect the central bank to implement a total of 125 basis points of easing in 2025.

That said, our ECB outlook is largely priced into the Overnight Index Swap curve. Forecasters have sharply downgraded the Eurozone outlook in relation to the US. For instance, the consensus GDP forecast for Germany in 2025 is only 0.4%, while that for the US is around 2.2%. With the market already very pessimistic on the Eurozone outlook, the bar is high for downside surprises.

Indeed, we’re tracking some possible upside catalysts closely. For instance, if the German election on February 23 leads to a strong centre-right coalition headed by Friedrich Merz, Germany may be able to engage with Trump more effectively. The new government may also finally reform the Schuldenbremse (“debt brake”) to deploy much-needed fiscal ammunition in dealing with Germany’s high energy costs and loss of competitiveness. The peace dividend from a possible end to the war in Ukraine may also boost investor confidence in the Eurozone.

In a widely published interview in November, Bank of Japan Governor Kazuo Ueda noted that the weak yen would trigger countermeasures. At that time, the USDJPY was around 150. Despite this, the BoJ held rates at 0.25% at its December Monetary Policy Committee meeting, citing the need to confirm wage pressures from the annual spring wage negotiations (“Shunto”), which sent the USDJPY surging to 156. This highlights that investors should focus on the BoJ’s actions rather than its statements. We believe the BoJ is reactive to yen weakness, preferring easy money policies and changing gears only when the currency plummets.

In fact, a virtuous cycle between wages and prices is already evident. Most analysts expect the upcoming Shunto round to deliver a wage hike of over 3% and a core CPI of over 2% in 2025. However, the average Japanese household isn't feeling better for it. Real disposable income and consumption expenditure remain below post-Covid levels, despite large fiscal transfers to households, including a tax cut last year. Negative real rates can inflate nominal GDP, but in a nation of savers, they harm real incomes. Remarkably, Japan had the highest CPI inflation among G7 countries in 2024 and the lowest real consumer spending growth.

The risk of a policy mistake in Japan is quite high. We do not rule out the risk of another plunge in the yen to 165 or weaker, perhaps around mid-year. However, such volatility would be self-limiting as it would force the BoJ to shift gears and be more proactive about policy normalization. We expect the yen to end the year on strong footing. 

While the United Kingdom’s growth is likely to remain sluggish in 2025, some factors could help the UK economy outperform the Eurozone’s.

First, the UK has a more expansionary fiscal stance. Its fall budget was notably more expansionary than market expectations. The Office for Budget Responsibility revised up its forecast for the cyclically adjusted primary deficit by 1.1% of GDP. Most of this will be implemented in Q1 2025 when public-sector pay hikes are implemented.

Second, the UK has a much higher share of services in its exports and runs a bilateral trade deficit with the US. This may leave the UK less exposed to the risk of US tariffs, at least compared to the Eurozone which has a much more egregious trade surplus with the US.

But it won’t be smooth sailing for the pound, which is trading near the top of recent ranges versus the euro, Canadian dollar and Swiss franc. Moreover, the market is pricing in only about 60 basis points in cuts by the BoE, compared to 125 basis points for the ECB. We think there is room for that pricing to converge and expect 75 to 100 basis points in cuts from the BoE, in line with Governor Andrew Baily’s December guidance of four 25-basis point reductions.

Moreover, the Gilt crisis of 2022 continues to hang over UK economy. While the market structure has been strengthened to prevent a crisis of that scale, the government’s escalating debt burden is once again a source of concern for investors. If the surge in long-term bond yields is sustained, it could pressure the UK government to tighten fiscal policy and lead to an abrupt slowdown in the economy. This would be bearish for the pound.

In summary, the UK’s economy could outperform the Eurozone’s, and the BoE would need to cut by less than the ECB. However, given the richness of current levels, the scope for outperformance is limited.