Foreign Exchange Outlook

MARKET TONE

The US dollar (USD) is strengthening into the end of Q2 and its gains are being driven by fundamentals as markets have moved to re-price a considerable amount of Fed tightening in the aftermath of the June FOMC. The outlook for relative central bank policy is dominating and currency markets are shifting away from the sentiment-driven movement that has characterized much of the price action that we’ve observed since the outbreak of the US / Iran conflict in early March.

Current levels reflect a combination of both fundamental and sentiment-related support resulting from the Fed’s hawkish repricing and lingering geopolitical concerns. The balance of risk appears to be somewhat skewed to the downside however, as we maintain a dovish outlook for the Fed and see additional downside risks for the USD as markets re-price for an easing in geopolitical tensions following the peace deal between the US and Iran.

We see few catalysts for additional USD strength from here, and note that current levels in the DXY have been met with considerable resistance over the past year or so.

We have made no changes to our FX forecast and we remain focused on the material downside risks to the USD. Tactical considerations—Fed pricing, sentiment—suggest an exhaustion of near-term support and cyclical risks remain firmly tilted to the downside as the US economy’s ‘twin deficits’ (trade, fiscal) erode longer-term support.

Fed Chair Warsh’s first meeting delivered a hold that was hawkishly interpreted by markets while offering little in terms of guidance. The Chair communicated a forceful commitment to price stability while also announcing the creation of several task forces to evaluate the Fed’s communication, its balance sheet, data sources and measurement, productivity, and the central bank’s inflation framework.

All of these areas offer the potential for a lower policy path, as we consider the conventional policy response to balance sheet normalization and declining measures of narrower (trimmed-mean, median) measures of inflation.

Most of the Fed’s peer central banks are constrained by single mandates, with a primary focus on headline measures of inflation that have been impacted by the rapid rise in energy costs. Single-mandate, inflation-targeting central banks will maintain a hawkish bias in both their guidance and their policy execution as they push back against the risk of second round inflationary pressures. The divergence in policy rate paths remains a core pillar of our fundamental outlook. Narrowing interest rate differentials have been a critical driver of the broad weakening in the USD from its 2022 peak, and we expect this trend to continue into the end of our forecast horizon.

Growth trends in the US are worrisome, as consumer sentiment remains weak, and forward-looking indices like the Atlanta Fed’s GDPNow suggest a material softening into the second half of 2026. Recent growth has also been relatively narrow, and much of it has been powered by significant AI-lead investment spending related to data centres. The US housing market remains incredibly weak, reflecting poor sentiment among homebuilders and ongoing homebuyer-related headwinds tied to the recent rise in mortgage rates.

Scotiabank’s central bank forecasts remain directionally unchanged. The Fed is expected to deliver 50bps of easing with one 25bp cut in Q4 2026 and another in Q1 2027. The terminal rate remains at 3.25%.

The Canadian dollar (CAD) has suffered through the latter half of Q2, weakening to fresh 2026 lows on the back of a material widening in US-Canada yield spreads. The BoC’s cautious hawkishness has offered a minor headwind, especially when contrasted with the material shift in the Fed’s outlook.

The balance of risk favours CAD strength from current levels as market sentiment and positioning largely incorporate many of the downside risks while offering little to those looking for a recovery. The medium-term chart continues to be one of retracement, as the CAD recovers from its late 2025/early 2025 decline. Our fair value CAD estimate continues to hover above spot levels, suggesting some pressures unrelated to fundamentals.

The Bank of Canada forecast was most recently adjusted for timing. The BoC’s terminal rate is unchanged at 3.25%. We have maintained our bearish USDCAD forecast with a Q4 2026 target at 1.33, extending to 1.30 by Q4 2027.

The EUR’s performance has been dull, owing to its flat one-year range with movement largely centred around 1.15. The retreat from the multi-year January high above 1.20 has been frustrating but also relatively muted, suggesting persistent EUR support in the face of shorter-term headwinds.

The fundamental support has been important, reflecting an ECB that has adopted a much more decidedly hawkish tone and actually delivered the first hike among the G4 (Fed, ECB, BoE, BoJ) central banks since the start of the crisis. This has been followed by the BoJ, delivering the next hike—its first since early 2025—in mid-June. The JPY’s muted reaction suggests a desire from market participants for a more forceful commitment to price stability. The yen continues to trade at relatively weak levels, and markets remain concerned about the possibility of official currency management (intervention).

Sterling’s (GBP) prospects remain solid, despite near-term political risks related to the Labour party’s leadership. PM Starmer’s government has been continually buffeted by recurring political issues, opening up the potential for a leadership challenge. The BoE’s hawkish stance has softened somewhat, but the central bank is still expected to deliver 50bps in the back half of 2026. Fiscal concerns have softened and key officials have sought to reinforce the government’s commitment to self-imposed fiscal rules.

The Australian dollar’s (AUD) performance has been notable, delivering fresh multi-year highs on the back of a clear retracement of the decline from 2021. We recently made a modest upward adjustment to the AUD forecast, reflecting earlier than expected gains. For Latam FX, the MXN’s performance has been impressive, delivering 4+% gains over the course of Q2. Markets appear reassured by President Sheinbaum’s approach to USMCA negotiations. The PEN’s modest gain has masked considerable volatility related to the 2026 Presidential Election, whose June runoff has failed to deliver a clear winner at the time of printing.

Eric Theoret, Canada 416.863.5934

FX FORECASTS

CAD FX FORECASTS

FEDERAL RESERVE AND BANK OF CANADA MONETARY POLICY OUTLOOK

FEDERAL RESERVE—WARSH JUST TOLD YOU NOT TO PRE-JUDGE!

As Chair Warsh embarks on a fresh mission to reinvent the operational framework surrounding the conduct of US monetary policy, we counsel clients to expect high volatility, but also greater patience than presently priced for future moves.

Markets are largely pricing a hike by the September FOMC despite 50–50 hold-hike divisions. There are several reasons why we think this may be worth receiving in OIS and hence being careful toward dollar strength.

One major reason is that Warsh was careful to emphasize that he didn’t wish to pre-judge the outcome of what five taskforces will report back on starting in the Fall and probably concluding by year-end. To hike as soon as September would pre-judge their guidance and recommendations.

Those taskforces will leave no stone unturned. One will look at Fed communications including the future of the projections, dot plot and press conferences. Another will opine on balance sheet management goals. A third will seek to expand upon and modernize the data toolkit. A fourth will delve into productivity and jobs including how AI and other tech may impact the labour market. A fifth will re-examine the inflation framework—excluding the sacrosanct 2% target—particularly on issues like the best measures.

As Warsh has previously indicated, his preference leans toward trimmed mean PCE that remains trending lower than traditional core PCE. He may argue that today is more about a relative price shock than generalized inflation and monetary policy should look through the former. 

How the FOMC judges the state of the labour market depends upon annual benchmarking revisions just before the September FOMC, how hiring holds up into further weakness for household incomes and a plunging saving rate, and what the taskforce says about how rapid tech innovation and jobs.

And while the FOMC would say they conduct independent monetary policy, the current political climate would invite Congressional attacks should they rush hikes before mid-term elections on November 7^th. Go ahead, poke the bear.

BANK OF CANADA— BIG BROTHER WENT OFF TO COLLEGE

Our forecast remains in favour of rate hikes beginning toward year-end and continuing into next year. Cumulative tightening of 75bps over 2026Q4 and 2027Q1 remains our baseline.

Our hike view extends to last November and hence pre-dated the Iran war and the concomitant shock to commodity prices. That’s an important first point in that the decline in commodity prices of late does not change our view that the economy would gradually re-emerge from an underlying soft patch on core inflation. We are seeing nascent signs of this already with the average of trimmed mean and weighted median CPI over 2% m/m SAAR over the past two months.

We’re sceptical that the US-Iran MOU will be durable which could maintain a geopolitical premium across commodity prices. Energy is off the peaks but still expected to remain well above pre-war levels with passthrough still assumed.

We forecast slack to narrow as the economy rebounds with the help of negative real rates due to passive easing, ongoing fiscal supports and the beneficial effects of commodities. Soaring import and producer prices pose material passthrough risk into consumer prices. Productivity-adjusted wages keep rising. So do inventories. Overall cost pressures represented by these factors are accompanied by the costs of trade diversion in light of US protectionism to find new suppliers, new markets, new products and rejigged production. Inflation expectations are above target.

And the BoC’s Big Brother has gone off to college, blowing the BoC’s cover. As Chair Warsh embarks on an uncertain agenda marked by the creation of five taskforces to report back by year-end the market has assumed a more hawkish FOMC outcome that is punishing USDCAD. At over 1.41, the currency is beginning to test the BoC’s tolerances in the context of other sources of imported price pressures and at the widest policy rate differential in decades.\

Derek Holt, Canada 416.863.7707

NORTH AMERICA

MAJOR CURRENCIES

MAJOR CURRENCIES (continued...)

LATIN AMERICA