Still in the Shallows

USD: Still on track; The headline figure for August payrolls proved to be slightly stronger than anticipated. However, this positive development was offset by downward revisions to previous months' data. Furthermore, there was a notable increase in labour force participation, which was encouraging. When we consider this data in conjunction with the JOLTS and PCE inflation reports released earlier in the week, it appears that there is sufficient evidence of progress towards achieving disinflation and rebalancing the labour market. As a result, it is likely that the Federal Open Market Committee (FOMC) will maintain its current stance in September.

Although wage growth remains elevated, it will continue to fuel debates about the necessity for further tightening measures beyond September. Nevertheless, my outlook of a 'Shallow Dollar Depreciation' remains on course after a pivotal week. I anticipate that the path from now until the end of the year will largely mirror the differentiated performance of the Dollar seen in foreign exchange (FX) markets year-to-date, as illustrated in Exhibit 1. 

Exhibit 1: FX markets have been more differentiated in 2023 than in 2022, netting out to a roughly flat broad Dollar YTD and “shallow Dollar depreciation” since the peak last Autumn

Source: Bloomberg, Goldman Sachs Global Investment Research

My baseline macroeconomic forecasts point towards several factors: Firstly, I expect lower rate volatility due to a cautious Federal Reserve (Fed). Secondly, while U.S. economic growth remains robust, it is showing signs of slowing down. Thirdly, risk sentiment remains supportive. These factors collectively suggest a weaker Dollar backdrop against more pro-cyclical FX.

However, it's worth noting that there is a potential for sustained Dollar strength, which might be underestimated by many market participants, especially against certain major 'Challenger' currencies like the Japanese Yen (JPY) and the Chinese Yuan (CNY). The Euro is emerging as a critical factor in FX markets through the end of the year. If the Eurozone's economic growth appears less resilient than my current expectations, and concerns about China persist, it could lead to greater upside for the U.S. Dollar, potentially limiting gains for cyclical currencies.

On the other hand, if Eurozone growth remains positive, as Goldman Sachs economists anticipate, my year-end target for EUR/USD at 1.10, along with my view of continued support for cyclical FX, should remain intact. Consequently, I favour relative value opportunities across G10 and emerging markets (EM) on a tactical horizon. This includes positions such as short EUR/CAD, long BRL and COP against CNY, and short TWD/KRW. I also believe that cross-JPY pairs, particularly CHF/JPY and GBP/JPY, still have room to appreciate, driven by my expectation of gradual JPY depreciation, even though these pairs are already at stretched levels.

CAD: Help from the hawks; Despite a relatively weak Q2 GDP report, the likelihood of a Bank of Canada (BoC) interest rate hike in the upcoming week appears to be somewhat elevated. Since the last BoC meeting, there has been limited evidence of a slowdown in inflation within the BoC's preferred core metrics. The central bank has emphasized the importance of progress in addressing inflation concerns. While recent cooling in the labour market may alleviate some upward pressure on prices, it seems that additional tightening measures may be necessary to reach the inflation target.

However, my perspective is that the BoC is more likely to signal a slower pace of rate increases, in line with my forecasts. They may point to the cooling labour market and a Q2 GDP report that falls well below expectations as evidence that the previous rate hikes are beginning to have an impact on the economy. Nevertheless, I believe that more actions may be required, and if the BoC shares this view, an interest rate hike in the upcoming week could be warranted, especially considering that the threshold for pausing rate hikes has increased.

I believe there is an attractive risk-reward scenario in taking a tactical short position on EUR/CAD. The Canadian Dollar (CAD) is expected to benefit from a more favourable outlook for U.S. economic growth, particularly when compared to the Euro (EUR), where incoming economic data has remained weak. Additionally, there is the potential for a boost from a more hawkish stance by the BoC, assuming my assessment that another rate hike is warranted by the October meeting proves accurate. 

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