FX & Rates Strategy: Increasing Uncertainties Amidst Rising Risk To US Economy

Fed monetary policy

The US Federal Reserve (Fed) may have hit the pause button in its rate hiking cycle, but this is of little reprieve for investors as the growing list of risks against the US economy is getting longer and more worrisome. These range from the on-going US regional banking crisis to the increasing risk of US debt ceiling default as a result of more extreme brinksmanship.

The US regional banking crisis that started two months ago continues unabated. Lingering doubts remain about the health and quality of the balance sheet of US regional banks. Deposit outflow continued amidst the concurrent jump into the perceived safe haven of US money market mutual funds.

US Treasury Secretary Janet Yellen has warned that X-date is likely to be in June and White House has quoted various dire predictions from rating agencies on how severe a debt ceiling default will damage the US economy. Judging from the jump in US sovereign Credit Default Swap (CDS) in recent weeks, investors are not confident that the debt ceiling stalemate will be solved anytime soon.

In terms of Fed monetary policy outlook, a pause at 5.25% for the rest of 2023 is our base case. But markets continue to imply substantial rate cuts by end of the year, an expectation which Fed Chair Jerome Powell has characterized as “not appropriate”. As such, a wide policy expectation gap exists, which creates the condition for renewed volatility in rates markets.

Major FX Strategy

In the Majors FX space, now that the Fed has likely paused its hiking cycle, the differentiation of monetary policy between the Fed and other Developed Markets (DM) central banks will likely set the stage for further weakness of the DXY. While the Fed has likely halted its tightening cycle, the European Central Bank (ECB), Bank of England (BOE), Reserve Bank of New Zealand (RBNZ) appear more hawkish. The current value of the DXY at about 102 screened as being “overvalued” relative to the interest rate spread of USD versus its DXY peers, lending scope for a further decline in DXY. We reiterate our view of a lower DXY, towards 96.7 by 1Q24. This means the rate advantage of the USD will continue to erode going forward, as such we stay positive on the EUR, GBP, AUD and NZD.

Asia FX Strategy

As for Asia FX, we stay cautious in the current quarter due to potential risk aversion from the ongoing US banking sector turmoil. May is also a seasonally weak month for the Asia Dollar Index as a whole and the weakest month for KRW (-1.8%, average over last 10 years), MYR (-1.7%), INR (-1.2%), SGD (-1.2%), THB (-1.0%) and TWD (-0.7%). Overall, we keep to the view of a higher USD/Asia in 2Q23 before clearer signs of a sustained China economic recovery spur renewed weakness of USD/Asia in 2H23.

As the China economic fog stays in the near term, we maintain our cautious view on CNY and expect USD/CNY at 6.95 by end-2Q23. In 2H23, when clearer signs of a sustained and broad-based economic recovery emerge, CNY is likely to strengthen anew. The recent upgrade of China’s 2023 GDP to 5.6% from 5.2% also adds conviction to a subsequent recovery of CNY to 6.80 /USD by 4Q23.

The latest policy pause by the Monetary Authority of Singapore (MAS) in Apr probably marked the end of the tightening cycle that began in Oct 2021. Consequently, the SGD has gained against all of its trade basket peers (except CHF), even against the strong USD. In all, our updated USD/SGD are at 1.34 in 2Q23, 1.32 in 3Q23, 1.31 in 4Q23 and 1.30 in 1Q24, compared to previous forecasts of 1.34, 1.32, 1.30 and 1.28 respectively.

In view of the domestic growth slowdown, the State Bank of Vietnam (SBV) became the first Asian central bank to ease policy and has also set a 12-month debt suspension for struggling firms. At this juncture, we do not expect the domestic growth headwinds to be severe enough – our 2023 GDP forecast is still respectable at 6.0% vs 2022’s 8.0%. Overall, we expect USD/VND to trace other USD/Asia pairs higher to 23,600 in 2Q23 before easing lower to 23,500 in 3Q23, 23,400 in 4Q23 and 23,300 in 1Q24. Consequently, USD/VND exchange rate is forecasted to move in a tight range around 23,300/23,600 level while VND policy rates are expected to have another 0.5% rate cut in the coming months.

Rates Strategy

The US debt ceiling default risk is back and more intense than ever. This risk is expressed unevenly across various asset classes. We take this opportunity in this monthly to discuss the implications in T-bills, Credit Default Swaps (CDS) and FX markets.

FX, Interest rates & commodities

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