MARKET TONE
The US dollar (USD) has been trading defensively over the past two months and looks to be in the early stages of a bearish reversal as we head into the end of Q3. Price action in the DXY has largely mirrored the shift in fundamentals with a clear erosion in support offered by interest rate differentials as the outlook for relative central bank policy makes a renewed bearish turn against the USD.
Expectations for Fed tightening continue to lean hawkish however the outlook for near-term tightening has faded somewhat with a notable moderation in the pricing of rate hikes this year. Fed Chair Warsh has forcefully defended the central bank’s commitment to price stability and the pursuit of a 2% inflation target while simultaneously exhibiting a considerable amount of caution in the Fed’s overall assessment of inflation.
Beyond the Fed, major developed economy central banks are turning increasingly hawkish. The ECB and BoJ have prepared markets for rate hikes at their September meetings, and the BoE is leaning toward a move before year-end. The Bank of Canada delivered a hawkish hold at its September meeting, removing language that deemed current policy settings as appropriate on the back of renewed inflation concerns. Interest rate differentials have broadly narrowed in favour of gains for most G10 currencies.
Sentiment and positioning have also turned against the USD. Pricing in the options market has revealed a meaningful moderation in the premium for protection against upside risk in the USD. Risk reversals have returned to neutral levels, completely reversing the gains that were observed in response to the outbreak of tensions between the US and Iran in March. Positioning data have provided additional confirmation to the broader shift in USD risk, as weekly CFTC reports have revealed a significant liquidation of bullish USD bets against most of the reporting currencies.
Scotiabank’s FX forecast maintains a broadly bearish USD outlook on the basis of fundamentals. The central bank outlook anticipates a neutral policy stance at the Fed as policymakers on the FOMC look beyond short-term inflationary pressures. Current market pricing offers downside risk for the USD given that fed funds futures are implying just over 40bps of tightening by year-end. The neutral Fed view also reflects Chair Warsh’s ambitious and potentially transformative effort to re-evaluate the central bank’s policy framework.
Structural risks for the USD remain equally concerning, as market participants assess the US economy’s sizeable fiscal and current account deficits. The current administration’s efforts to address these key vulnerabilities have not yielded any meaningful results, leaving the balance of risk for the USD firmly tilted to the downside.
Lastly, we remain concerned about USD risks related to the state of international investment positions. Global portfolio balances are still overwhelmingly allocated to the US and USD-denominated investments, owing to the long-term outperformance of the USD and US equity investments. Global investors appear relatively unprepared for an environment of extended, broad-based USD weakness and efforts to protect against this risk could intensify its headwinds.
The USD’s longer-term chart remains bearish, with a clear reversal from its 2022 peak. We note the sequence of lower highs and lower lows that have followed, and highlight the fact that the DXY remains well above its 20-year moving average.
The Canadian dollar (CAD) has staged clear recovery since late June, showing impressive resilience in the context of intensified trade policy uncertainty and a significant deterioration in the US-Canada relationship.
The Bank of Canada has shifted its guidance, softening its neutral stance in response to renewed inflation concerns. The Canadian economy’s resilience has also played an important role, offering reassurance to policymakers as they seek to manage ongoing trade tensions.
Yield spreads have narrowed in the CAD’s favour, reflecting both a softened Fed outlook and a renewed confidence in expectations for tightening from the BoC. We maintain a bullish longer-term outlook for the CAD, with a neutral Fed view that is set against a BoC forecast that anticipates 75bps of tightening.
Sentiment and positioning have also shifted in the CAD’s favour, signaling a material reassessment of the CAD’s prospects in light of improving fundamentals.
We have maintained our bearish USDCAD forecast with a declining profile targeting 1.37 for Q4 2026 and 1.33 by Q4 2027.
Price action in the EUR has been constructive, with a notable recovery since late June. Yield spreads have provided fundamental support while sentiment and positioning have delivered additional tailwinds.
The ECB’s hawkish tone has intensified, and policymakers have guided expectations for a rate hike at the September meeting with additional tightening expected by the end of the year. The BoJ has recommitted to a tightening path following recent currency weakness and policymakers have made clear, high-profile efforts to prepare markets for a hike in September and future tightening thereafter.
For the GBP, its gains from late June have been primarily driven by a recovery in sentiment as markets have expressed relief following the arrival of PM Burnham. Recent hawkishness from the BoE has provided additional support, however market participants remain focused on the government’s fiscal plans and its efforts to maintain confidence into the budget release scheduled for late October.
Other developed economy commodity currencies like the AUD and NZD have delivered an impressive performance through much of Q3, supported by policy action and guidance from both the RBA and RBNZ as well as broader commodity price gains that have delivered a continued improvement in their terms of trade.
In Latam, the MXN remains well supported testing fresh multi-year highs in an environment of improving market sentiment related to the broader tone and relief tied to the constructive tenor of US-Mexico trade negotiations. The PEN has recovered back to the upper end of its multi-year range as market participants have moved on from politically-related uncertainty, while the CLP continues to struggle as growth concerns dominate the support offered by record prices in copper.
Eric Theoret, Canada 416.863.5934
FX FORECASTS
CAD FX FORECASTS
FEDERAL RESERVE AND BANK OF CANADA MONETARY POLICY OUTLOOK
FEDERAL RESERVE—TALK TOUGH, HANG TIGHT?
Scotiabank Economics forecasts the Federal Reserve to be on hold at 3.75% throughout the remainder of this year and all of 2027.
It is not a forecast we issue with a great deal of confidence. We acknowledge near-term risk of further tightening but future risk of easing. On net, our curve view is that US yields are broaching unsustainably high levels if the longer-run neutral policy rate is around 3%, the term premium has already sharply risen to the highest in over a decade, and longer-run market inflation expectations are relatively high.
The present policy rate is moderately restrictive and probably high enough to counter inflation risk when paired with the bond market’s tightening of financial conditions.
In favour of tighter policy is that underlying core PCE inflation remains too high with the 3moMA tracking about 3% m/m SAAR. The US economy is judged to be in excess demand. The fragile state of the bond market may see further curve steepening if the policy rate is not increased.
In favour of being cautious is that the job market has recently surprised higher, but we view it as weaker than other depictions. August’s payroll gain was entirely driven by a fishy seasonal adjustment factor just as a new Trump-appointed BLS Commissioner took over. Nominal wage growth of 3% y/y is flat in real terms, the housing wealth effect is negative as real house prices decline, and the saving rate is about zero in real terms. We think that higher oil prices in this context are more likely to create second-round disinflationary effects reinforced by corporate belt tightening.
That is expected to coincide with fiscal policy tightening as a drag on growth over coming quarters. Care should be taken in adding monetary tightening.
Yet where much of our uncertainty lies is around unstable communications from Chair Warsh and waiting for answers from his five task forces. Setting a precedent by starting a tightening cycle just before the US midterms is fraught with political danger for the Fed.
BANK OF CANADA—NO TIME FOR TEASING
The Bank of Canada’s recently hawkish pivot has emboldened our long-held view dating back to last November that the BoC would begin a hiking cycle by late year extending into next year.
There were three defining features of recent communications. The statement struck out “the current policy rate remains appropriate.” Theoretically that’s directionally ambiguous.
It’s a hawkish move when paired with the warning that “upside risks to inflation have increased.”
Then note the thinly veiled guidance that says “We will have a new forecast at our next meeting. Our interest rate decisions will be guided by the outlook for inflation. That will be front and centre in our next decision.”
You don’t drop a key forward guidance sentence, warn on inflation risks, use language that intimates a move conditioned around fresh forecasts, then issue said forecasts, only to whiff.
Developments since the September communications have been somewhat mixed but mostly supportive of tighter policy. Canada lost 42k jobs in August, after strong gains in four of the prior five. Hours worked are tracking an explosive 5% q/q SAAR gain in Q3 which strongly leans toward sustained GDP growth. We forecast that the output gap will shut within 1-2 quarters. The BoC may therefore already be behind inflation risk given lagging effects of policy moves.
Layer on surging oil prices, expectations for bigger and more rapid deployment of fiscal firepower and small effects of new US trade actions and we believe that there is a multi-pronged case for moving away from the lower bound of the neutral rate range with a real policy rate around zero.
As for inflation data dependence, traditional core inflation has been running at over 3% m/m SAAR for three straight months. It is the better guide to future headline inflation in our shop’s research. Trimmed mean and weighted median CPI recently accelerated to 2¾% m/m SAAR and are at 2% y/y.
Derek Holt, Canada 416.863.7707
NORTH AMERICA
MAJOR CURRENCIES
MAJOR CURRENCIES (continued...)
LATIN AMERICA
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FOREIGN EXCHANGE STRATEGY
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Scotiabank, together with “Global Banking and Markets”, is a marketing name for the global corporate and investment banking and capital markets businesses of The Bank of Nova Scotia and certain of its affiliates in the countries where they operate, including; Scotiabank Europe plc; Scotiabank (Ireland) Designated Activity Company; Scotiabank Inverlat S.A., Institución de Banca Múltiple, Grupo Financiero Scotiabank Inverlat, Scotia Inverlat Casa de Bolsa, S.A. de C.V., Grupo Financiero Scotiabank Inverlat, Scotia Inverlat Derivados S.A. de C.V. – all members of the Scotiabank group and authorized users of the Scotiabank mark. The Bank of Nova Scotia is incorporated in Canada with limited liability and is authorised and regulated by the Office of the Superintendent of Financial Institutions Canada. The Bank of Nova Scotia is authorized by the UK Prudential Regulation Authority and is subject to regulation by the UK Financial Conduct Authority and limited regulation by the UK Prudential Regulation Authority. Details about the extent of The Bank of Nova Scotia's regulation by the UK Prudential Regulation Authority are available from us on request. Scotiabank Europe plc is authorized by the UK Prudential Regulation Authority and regulated by the UK Financial Conduct Authority and the UK Prudential Regulation Authority.
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