The USD’s rally, especially this year, has been powered by the idea of steadily higher interest rates emerging in the US and the impact of tighter policy on yield spreads relative to the USD’s major currency peers. Now, with swaps already reflecting expectations that the Fed Funds target rate will nearly reach 3%—the upper end of the broad neutral range—in early 2023, there is little chance of short-term rates rising that much more—at least for the next few months until the Fed has a better chance of assessing whether rates need to be more restrictive. In effect, the Fed’s tightening plans now look to be fully priced by markets. We think the USD trend is likely to transition into a broad, choppy, sideways range trade. Currencies where central bank policy has lagged the Fed but may now play “catch up”—the AUD is one stand out candidate—may fare relatively better, but we think scope for gains among the likes of the EUR, JPY or GBP is limited for the moment; central bank policy is unlikely to tighten in Japan any time soon while market pricing for ECB and BoE tightening also look relatively “full”—and still overextended for the latter. - Scotiabank FX Strategy
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