Recent developments in financial markets have significantly impacted the outlook for the USD. Various factors are contributing to the evolving sentiment, including expectations around the Federal Reserve's monetary policy and political uncertainties.

Factors Influencing USD Performance
Federal Reserve's Potential Easing Cycle

Market expectations are increasingly leaning towards the Federal Reserve initiating an easing cycle as early as September. This anticipated policy shift is likely to result in USD underperformance as lower interest rates reduce the currency's appeal to investors.

Comments from political figures, particularly around the impact of USD strength on international competitiveness, have triggered a reassessment of the USD outlook.

The potential for a Donald Trump presidency has introduced uncertainties, with policies that may either support or hinder the USD's performance.

Investors currently hold long positions in the USD, contributing to its strength. However, the USD is trading at a premium relative to fundamental drivers like US Treasury yields and interest rates, suggesting potential for a correction.

Despite the current headwinds, there are several reasons to maintain a broadly constructive view of the USD for the latter half of 2024:

US Rates Market Dynamics

The US rates markets may have overestimated the likelihood of an aggressive dovish pivot by the Federal Reserve. A more measured approach by the Fed could support the USD by keeping interest rates relatively high.

A potential 'weak-USD doctrine' could enhance the inflationary impact of other economic policies, such as trade tariffs and fiscal stimulus. This could lead the Fed to maintain a hawkish stance for a longer period, providing support to the USD.

Political developments, such as a GOP sweep of Congress, could emphasize the USD-positive aspects of the policy mix. Additionally, the USD might be bought as a hedge against volatility stemming from US political and global geopolitical risks in Q4 2024.

Fed Rate Cut Expectations

Expectations around Fed rate cuts will be a crucial driver for the USD in the near term. It is anticipated that the Fed will keep rates on hold at the upcoming meeting, with a possible rate cut in September being highly data dependent but I still believe that the market is pricing it wrong, and the cut will occur on November 7, 2 days after elections.

This week's June core PCE print will be closely watched for signs of persistent inflation. Higher-than-expected inflation could challenge the market's dovish outlook for the Fed, potentially boosting the USD.

Canadian money markets are pressuring the Bank of Canada to implement consecutive rate cuts. In Europe, FX investors are focusing on the Eurozone and UK PMIs, as well as the German Ifo index, for indications of economic recovery momentum.

The outlook for the USD is influenced by a complex interplay of monetary policy expectations, political developments, and investor sentiment. While there are significant headwinds in the near term, the potential for a more measured Fed response and the impact of economic policies could provide support for the USD.

Investors should remain vigilant to upcoming economic data and political developments, which will play crucial roles in shaping the USD's performance in the coming months

Market commentary and analysis from Luca Santos, market analyst at ACY Securities