Credit Ágricole: FX Weekly - FJElite
One of the most significant recent developments regarding the USD flow- backdrop has been the dramatic shift in the way the US current account deficit is being financed by foreign investors. According to the latest US TIC data, more than 80% of all the foreign capital inflows over the past year went into risk-correlated USD assets, with the remaining c.19% used to buy safe-haven USTs. The current breakdown between foreign-owned risk-correlated and safe-haven US assets could have a lasting impact on the way the USD performs during bouts of improving risk sentiment and/or spikes in risk aversion.
To see this, consider the ‘USD smile’, which links USD outperformance to spikes in risk aversion and higher US rates. Growing importance of risk-correlated foreign inflows into the US could erode the USD’s safe- haven appeal during risk aversion spikes - triggered by growing geopolitical risks or a tech-stock sell-off - as foreign investors are forced to reduce their exposure to risk and therefore to the USD. This could result in a flatter 'USD smile' that will not flatter the USD, given that investors may opt for safo-havon alternatives, eg, XAU.
Ahead of the July Fed meeting, the USD outlook will be increasingly impacted by the second key part of its eponymous smile - the evolution of US rates. The Fed is expected keep its rates on hold next week, making its forward guidance the key FX market driver. Also of interest would be the advanced Q2 GDP and the June core CPE data. We think that the current market expectations of two additional rate hikes in the coming months are too hawkish and believe that Fedspeak and US data would challenge that view, offering little support to the USD in the near term.
Elsewhere, focus next week will be on the BoE and BoJ policy meetings. Starting with the former, we expect the MPC to keep the bank rate on hold and stick to its non-committal policy stance that may disappoint still-too-hawkish UK rate investors. Market participants would also focus on any signals about the UK fiscal outlook and position accordingly. The BoJ is expected to keep its rates on hold, and Governor Kazuo Ueda could deliver another dovish press conference thus disappointing the overly hawkish market expectations, in a blow to the JPY.