USD rebounds after last week’s sell-off supported by Trump re-election odds

USD: Trump re-election odds support USD as Fed easing expectations weigh

The US dollar has continued to rebound at the start of this week supported by building expectations that the former President Donald Trump will win the US election in November. The probability of Trump winning the election has continued to increase on PredicitIt.com reaching a fresh high of 68% after the failed assassination attempt over the weekend. Those expectations have contributed to a further steeping of the US yield curve to reflect investor concerns over more inflationary policies (trade tariffs & lower taxes) if Trump is re-elected and the Republicans sweep Congress. The yield spread between the 2-year and 10-year US Treasury bonds widened by around 10bps over the past week to -24bps as it has moved back closer to the highest levels in recent years which came in at around -16bps. However, the level of US yields remains close to recent lows. The 2-year US Treasury yield is still trading just above 4.40% and the 10-year US Treasury yield at around 4.20%. While the increasing likelihood of Donald Trump being re-elected as President is placing upward pressure on US yields, it is begin offset at present by building expectations for the Fed to be more active in cutting rates in the year ahead in response to the recent run of  weaker US inflation data.

Those expectations for more active Fed rate cutting were supported overnight by comments from Fed Chair Powell who stated that softer inflation readings in Q2 have added “somewhat” to their confidence that inflation will return to their 2.0% target.  With inflation having come down and the labour market cooling off, he stated that the Fed will be looking at both their mandates. He reiterated that it there is an unexpected weakening in the labour market, it could be a reason for the Fed to react by cutting rates. However, he did not provide a strong signal over the likely timing of the Fed’s first rate cut. The US rate market has recently been moving more into line with our outlook for the Fed to deliver multiple rate cuts by the end of this year which has been an important assumption behind our outlook for a modestly weaker US dollar in the 2H of this year (click here). Even if Donald Trump is re-elected in November it will not prevent the Fed from cutting rates through the rest of this year and into early next year as it will take time for more inflationary policies to be implemented, and we remain confident that inflation and the US labour market will continue to slow in the year ahead. The US rate market has now moved to more than fully price in a 25bps cut into September and is even beginning to price in a small probability of the Fed delivering a larger 50bps cut. For this year as a whole the US rate market has moved to price in 75bps of Fed rate cuts and almost 150bps cuts by the middle of next year. 

YIELD SPREADS HAVE BEEN MOVING AGAINST USD RECENTLY

Source: Bloomberg, Macrobond & MUFG GMR

EM FX: Cross currents facing EM FX from US macro risks

Emerging market currencies have continued to rebound against the USD over the past week. The biggest winners have been the CLP (+2.3% vs. USD), PEN (+1.7%), COP (+1.7%), HUF (+1.2%) and MXN (+0.7%). While the ZAR (-0.7% vs. USD), TRY (-0.5%), RUB (-0.5%) and BRL(-0.4%) have underperformed. Latam FX and the HUF have benefitted from the pick-up in demand for carry currencies. The higher yields still on offer in South America and in Hungary have become more attractive as financial market volatility has dropped back in recent weeks.

The main trigger from improving conditions for carry trades heading into the summer are building expectations for the Fed to begin cutting rates in response to slowing US inflation. It has helped to put a dampener on financial market volatility and encouraged risk seeking behaviour amongst market participants. MSCS’s ACWI global equity index has risen to fresh record highs this month. The case for the Fed to start cutting rates soon has become more compelling after the release of the US CPI report for June revealed that inflation has slowed for the third consecutive month in Q2. Core inflation was flat for the second consecutive month in June and there was a step down in shelter inflation. The developments should give the Fed more confidence that inflation will continue to slow back towards their 2.0% target. It is probably too soon for the Fed to begin cutting rates later this month, but we expect a stronger signal to set up a September rate cut. The ongoing drop in short-term US yields is providing a headwind for USD performance in the near-term. Even the rising probability of Donald Trump being re-elected as President for a second term later this year has so far failed to trigger a reversal of the USD’s recent weakening trend.       

The increasing probability of Donald Trump being re-elected as President poses downside risks for emerging market currencies in the year ahead. The clearest transmission channel to EM FX is through trade policies.  Being the largest source of the US trade deficit, China will be the top EM target of the most punitive trade measures. Other EM contenders that may witness a greater push to restrict China rerouting US trade may include Mexico, Brazil, South Korea, Taiwan and Vietnam. As a result, Asian currencies including the CNY, KRW, TWD and VND are subject the greatest downside risks alongside other emerging market currencies such as the MXN, and BRL. Please see our latest EM EMEA Weekly for more details (click here)    

KEY RELEASES AND EVENTS

Source: Bloomberg