Global FX Views You Can Use: USD's Growth "Smile" Flirts with Inflation

Themes driving FX performance – Carry, risk and growth lead the way this year

The macro backdrop has undergone another regime shift and what's worked the past two years, is no longer working – particularly in terms of trade and G10 inflation. With the pushback in market expectations of cuts and FX volatility remaining low, carry is still generating impressive positive performance. Additionally, focus has also shifted to growth and risk.

Mean-reverting strategies like positioning and fair value can keep working as the transition plays out. In the new regime, carry can retain its crown status until the summer. After that, growth and risk are likely to become primary drivers of FX markets.

No volatility leaves crowded positions – USD breakout is limited by consensus herding

USD breakout contained by consensus views

The FX market has also clustered around a strong USD theme in Q1'24. However, positioning is getting crowded with herding starting to take shape. Of the currencies that we cover, all but the Chilean Peso (CLP), sit near the lows of the 3y range when we measure consensus variability, and well below the average. We think this is embedded in the price action and our positioning indicators, where the firmer USD captures the market herding around one view.

The USD's new inflation smile – USD can't seem to make up its mind about growth and inflation

Meet the USD's new inflation smile

A common theme in this month's Views You Can Use is the focus on inflation versus growth for the USD. A common pattern is that the market is increasingly interested in inflation hedges rather than recession hedges, underscoring the rally in gold. The USD's growth smile (where the USD outperforms in times of particularly strong or particularly weak growth) broke earlier this year, shifting to a new inflation smile.

The chart above plots relative growth and inflation data trends (U.S. versus Rest of World), and we make two points. First, growth has moved against the U.S., peaking in late 2023. Second, inflation trends have moved in the U.S.'s favor, kickstarting a shift of the USD's correlation toward inflation earlier this year.

Forecast updates and outlook

We made some notable changes to our forecasts this month, upgrading the USD a bit in Q2. We still anticipate the USD weakens through Q3 but have also penciled in some USD strength in Q4 and Q1 of 2025 to capture the geopolitical risks and uncertainty around the US election.

Notably, while improving global growth expectations and financial conditions could keep macro volatility subdued for a bit longer, we note the major disconnect between FX volatility (low) and geopolitical uncertainty (high). That should elevate the USD ahead of the 2024 U.S. election.