Claudio Wewel, FX strategist at J. Safra Sarasin Sustainable Asset Management sees factors pointing to a continued weakening in the position of the dollar.
In FX, all eyes remain on the dollar. In early May, the currency experienced a short comeback as President Trump struck a trade deal with the UK and a truce in the US-China trade war, pushing most G10 currencies temporarily lower. As market participants reduce dollar holdings, the debasement of the dollar is expected to continue.
Headwinds amid fiscal sustainability concerns
With President Trump’s ‘One Big Beautiful Bill Act’ passing the House of Representatives by a razor-thin majority, the market is set to remain strongly focused on the longer-term sustainability of US government debt. Some of the proposed spending cuts of the House bill could be diluted as it passes through the Senate. Yet the bond market will act as a guard rail, suggesting that US Treasury yields could rise even further at the long end of the curve, pushing the dollar lower as market participants intensify their efforts to move out of dollar-denominated assets.
Likely re-escalation on the trade front
On the trade front, a re-escalation is more likely than a further de-escalation. Even though Trump’s recent decisions have brought the effective US tariff rate down from 30% to around 15%, it is important to keep in mind that there is no enforcement mechanism. Hence the deals will only last until President Trump wants to renegotiate them. In our view, the recent re-escalation of the US-China trade war and the recent doubling of tariffs on steel and aluminium imports to 50% only serve as the latest cases in point.
Trump’s political goals remain unchanged
Stephen Miran’s Mar-a-Lago proposals, which include a user fee on foreign US government bond holdings or swapping US Treasuries for lower-interest-bearing ‘century bonds’, potentially in exchange for US security guarantees, are still on the table. According to recent news reports, foreign exchange policies are part of the ongoing US trade negotiations with Japan and South Korea. Overall, President Trump’s political goals are unlikely to have changed. Yet this would be crucial to restoring the cracks that have become visible in the US dollar’s safe haven status.
US cycle to slow
Given the recent robustness of US data, the relative cyclical outperformance of the US economy versus the rest of the world is more likely to diminish rather than to extend from here, which should be a drag on the dollar.
The dollar remains highly valued
Lastly, and perhaps most importantly, the dollar remains highly valued, with its real exchange rate substantially above its long-term average, in spite of the recent retracement. This is something that markets will duly consider in the current environment.
The euro is well-positioned
The euro is particularly well-positioned to benefit as investors seek to diversify their asset holdings away from the dollar. To this date, the euro constitutes the second largest reserve currency, and it has various economic and institutional characteristics that put it in an increasingly competitive position with the dollar. In particular, the rule of law may provide a competitive advantage, going forward. Aside from this structural trend, the euro should also benefit from Germany’s fiscal stimulus. Furthermore, option-implied volatility skews show that markets expect a stronger euro.
Strong Swiss franc, sterling headwinds
The Swiss franc is expected to hold up well amid elevated political and macro uncertainty. The perception that the SNB is moving closer to the end of the rate-cutting cycle should support the franc, even though the probability of negative policy rates has risen somewhat on the back of low inflation. In the UK, the sharp rise in April inflation limits the BoE’s room for further policy rate cuts and hence we expect pound sterling to soften only moderately against the euro, while it should continue to rise against the dollar.
Near-term upside risks for the yen
The outlook for the yen remains constructive. Japan will not easily concede in its trade negotiations with the US, implying that currency volatility should remain elevated in the near term. Yet there are near-term upside risks for the currency. A stronger yen could be part of an eventual trade deal between Japan and the US. Attractive long-term JGB yields may also turn into a tailwind as domestic investors seek to repatriate assets from the US. More broadly, the yen should benefit from a continuation of the broader dollar downward trend.
Gold should continue to rise
Following its 30% year-to-date performance, the gold rally stalled in May. A considerable improvement in risk sentiment, triggered by the US-UK trade deal and the US-China trade truce, led to tactical outflows from gold-backed ETFs in mid-May. Gold will push higher in the coming months. Institutional purchases remain strong, particularly in emerging markets, as central banks step up efforts to diversify away from dollar reserve assets. Some countries seeking to protect themselves from potential future sanctions are increasingly adopting payments in bullion, as the case of Iran demonstrates.
By Claudio Wewel, FX strategist at J. Safra Sarasin Sustainable Asset Management
