Broad USD strength is persisting, contrary to our expectations that the second half of the year would present a more challenging environment for it. The Federal Reserve (Fed) raised its policy rate to 5.50% in late July, and US yields have risen significantly since June due to resilient economic data and the belief that Fed policy will remain tight for an extended period. At the same time, the international environment has weakened and China’s growth rebound has failed to develop, leaving a weaker yuan (CNY) and adding to the strong, overall tone of the USD. The USD's essential support comes from its still favourable growth and yield advantages over major currency peers.

Prospects for a US soft landing have improved, and there are signs that the Fed is making progress toward its inflation goals. We do not anticipate the Fed tightening further and still expect growth to slow as the labour market softens and consumers retrench. The USD is trading stronger than expected, but the positive cyclical backdrop is largely factored in, and its broader upside potential is limited. With the Fed's tightening cycle seemingly complete, in our opinion, markets may soon begin to consider more precisely when and how quickly US rates will retreat. More neutral messaging on the policy outlook from the Fed or weaker economic data could be the catalyst for markets to reconsider the outlook for a still relatively expensive-looking USD.

Longer run structural challenges for the USD continue to linger in the background but are not a significant factor in USD sentiment at present. We mentioned rising deficits as a potential headwind for the USD in our July update, something that Fitch’s decision to cut the United States’ credit rating by one notch (to AA+) in August underscores. Fitch noted that it expects the US fiscal backdrop to weaken in the next few years and commented that governance in US fiscal and debt matters had deteriorated. We do not believe the “de-dollarization” issue represents a major challenge to the USD at present as there are no obvious alternatives but these sorts of developments will clearly stoke the debate about the USD’s status as the primary global reserve currency.

The Canadian dollar (CAD) has been unable to resist the broader USD advance since mid-year. The Bank of Canada (BoC) raised its benchmark rate to 5.00% in July and stood pat at its September policy decision. Short-term yield differentials have widened in favour of the USD in recent weeks while the CAD has failed to find any clear support from steady to firmer commodity prices which have boosted Canada’s terms of trade somewhat. Canadian data reports have suggested some slowing in growth momentum but there is still some evident resilience in the economy. The latest employment report delivered a stronger-than-expected increase in jobs and a healthy gain in hours worked in August which rather suggests activity may pick up again. The CAD is trading well below our forecast levels for Q3 but the currency looks undervalued from a fundamental point of view and the risk of more tightening from the BoC before year end is perhaps higher than markets are pricing at present. The CAD could still end the year close to 1.30. The Australian dollar (AUD) and New Zealand dollar (NZD) rank as the weakest performing major currencies in Q3 so far. Disappointing Chinese growth trends are weighing on AUD sentiment while New Zealand terms of trade have remained soft amid sliding dairy prices. 

In Mexico, the peso (MXN) weakened in August, posting its first monthly decline this year. Losses have extended in September so far. Mexican yields remain attractive, but investors may be reducing exposure to the MXN after a solid run to multi-year highs against the USD (which is down more than 13% against the MXN over the past year). Domestic yields have likely peaked and focus on the potential for rate cuts to start late this year as well as domestic issues (such as the looming election cycle) may be encouraging profit-taking. We anticipate USDMXN ending the year at 17.90. Elsewhere in the Pacific Alliance, currency performance so far in Q3 largely reflects underlying economic conditions. The Colombian peso (COP) has strengthened modestly amid resilient domestic growth trends; firmer crude oil prices are adding to tailwinds. But the weaker performances of the Peruvian sol (PEN) and Chilean peso (CLP) are a sign of weaker economic conditions and building pressure for more accommodative monetary policy settings.   

Both the euro (EUR) and the pound (GBP) have retreated from their mid-year highs against the USD, and the case for renewed gains has been undermined by persistently higher US interest rates and more USD-supportive yield differentials in recent weeks. The European Central Bank (ECB) raised interest rates for the tenth time this month but indicated the policy cycle may be complete. The Eurozone economy slipped into a mild recession around the turn of the year and growth trends remain anemic. Germany’s industrial sector has been weakened by soft foreign demand (China). Inflationary pressures in the Eurozone remain elevated, with headline and core inflation stuck around the 5% mark, but this final rate hike may satisfy ECB policymakers that they have done enough to curb prices. A maturing interest rate cycle may revive foreign interest in Eurozone stocks that helped support EUR gains earlier this year but investors, who remain broadly bullish on the EUR outlook, may start to reconsider positioning amid weak growth trends. The EUR’s recent losses have been disappointing from our point of view but its overall performance so far this year has been resilient.

Positive yield differentials relative to the USD have supported a 3% GBP gain versus the USD in year-to-date terms. While the BoE tightening cycle is maturing, rates may have to stay high for some time to bear down on elevated UK inflation (6.8% in the July year) amid a still relatively resilient economy. Recent economic revisions showed the UK economy returned to pre-pandemic levels at the end of 2021; previously, data had suggested the economy remained just below its pre-Covid peak through Q2 this year. Markets anticipate slower rate reductions in the UK relative to the US and Eurozone in the next few quarters which should provide the GBP with some broader underpinning.

The change in leadership at the Bank of Japan (BoJ) has led to a subtle change in approach to monetary policy settings. The central bank is tolerating somewhat higher long-term yields (the 10Y government bond yield touched 0.7% for the first time since 2014) and Governor Ueda suggested the central bank could exit negative rates next year if it was confident that wages and prices were rising sustainably. The change in policy tack may reflect market and economic conditions but may also have aim of providing the yen (JPY) with some support after the USD strengthened to near JPY148 at the start of September. Recall that the BoJ intervened directly in support of the JPY last year when the USD breached the JPY150 level. Peak US yields should limit broader USD gains but achieving our year-end target of 135 will likely necessitate a more supportive yield differential environment for the JPY.

Shaun Osborne, Canada 416.945.4538




The Federal Reserve is likely to keep its policy rate unchanged at 5.5% on September 20th while leaving the door open to the possibility of further tightening if required. The modest upside surprise in August’s core CPI reading will likely weigh on the minds of FOMC participants as they submit forecasts ahead of the meeting. What is nevertheless likely to dominate caution on the game day decision itself is uncertainty around the lagging effects of what they’ve done to date, the lagging effects of credit tightening net of resilient equities, plus key wildcard risks like a potential government shutdown and a likely UAW strike that could combine to drive GDP negative into Q4 with associated effects on the dual mandate variables. The FOMC will cite progress while remaining loathe to prematurely declare victory over inflationary imbalances especially in light of three prior soft patches for inflation during the pandemic that did not end well.


Scotiabank Economics expects the Bank of Canada to set a high bar for further tightening while remaining open to the possibility. One part of the reason is to manage markets that may otherwise prematurely price easing, but there is also a fundamentals argument for elevated inflation risk. Further gains in the terms of trade are being buoyed by energy prices and an undervalued currency that for now are helping to insulate against some of the deterioration in competitiveness. A round of fiscal stimulus measures is likely to unfold across the Federal and provincial governments on the path to upcoming Fall updates. Surging immigration is adding more to demand-side pressures than it is benefiting the supply side. Surging wage gains alongside tumbling productivity are both inflationary effects. Inventories in key sectors like housing and autos remain lean as offsets to other improved measures of supply chains. Transitory shocks from wildfires to strikes across multiple sectors and weather dampened the economy in Q2 but these effects are expected to stabilize and drive improved growth into Q4. 

Derek Holt, Canada 416.863.7707





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