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Monthly Foreign Exchange Outlook

Forecast rates against the US dollar - End-Q3 to End-Q2 2027

Notes: All FX rates are expressed as units of currency per US dollar bar EUR, GBP, AUD and NZD which are expressed as dollars per unit of currency. Data source spot close; Bloomberg closing rate as of 5:00pm London time, except VND which is local onshore closing rate. All consensus forecasts are Bloomberg sourced. 

US dollar

MARKET UPDATE

In July the US dollar weakened against the euro in terms of London closing rates, from 1.1422 to 1.1509. However, the dollar strengthened against the yen, from 162.53 to 159.23. The FOMC at its meeting in July kept the range for the federal funds unchanged at 3.75%-4.00%. The FOMC confirmed the end of QT effective December last year with the Fed no longer reducing UST bond holdings. MBS holdings continue to decline but are offset by buying of US T-bills, now estimated to be running at around USD 25bn per month.

OUTLOOK

The US dollar depreciation in July on a DXY basis the drop was 1.3% primarily reflecting a modest gain in EUR/USD but a big drop in USD/JPY. A lot happened in the rates space with yields in core G10 all rising as inflation fears return due to the re-escalation of the conflict in the Middle East and hence the rebound in energy prices. Financial market conditions are remarkably stable despite the rise in yields – G10 FX volatility in July hit the lowest since 2022, the VIX has been in the 15-20 range, credit spreads are remarkably tight, and key equity indices are close to record highs. Can these conditions continue to co-exist with longer-term yields hitting levels not seen since before the GFC? We believe that will become increasingly challenging and after the August lull, September and October could be the period in which we see higher G4 rates hit risk assets leading to a turn higher in volatility and a potential bigger risk-off episode. Another possible ceasefire (according to the US) reduces this risk perhaps but whether this is genuine and will hold is very unclear.

The FOMC meeting in July was remarkable more for what was not said than what was said. Chair Warsh repeatedly refused to provide an answer as to why the Fed Funds rate was not increased and appeared to imply that market rates moving higher was doing the Fed’s work. He appeared to imply a less interventionist approach to fighting inflation that investors did not like. The 2s10s steepened by the most in a year (10bps) as inflation expectations increased. The pricing for a rate cut in September dropped. Perceptions of a reluctance to hike were reinforced by President Trump’s comment after Warsh’s press conference ended that Warsh would “love to lower rates”. There were three dissents – all Presidents – and division between the Board of Governors and regional Presidents also does not help instil confidence. A further steepening of the yield curve is now more likely given the uncertainty over the Fed’s reaction function that points to increased longer-term rates volatility resulting in a larger term premium and a weaker US dollar.

We now see pricing for a Fed rate hike (we don’t expect one) remaining for longer than previously assumed and therefore the dollar should remain well supported over the coming months, especially against high-beta G10 if financial market conditions turn less favourable. Once the window for Fed hikes closes (as inflation recedes) we then expect US dollar depreciation to unfold – now more a story for 2027.

INTEREST RATE OUTLOOK

Japanese yen

MARKET UPDATE

In July the yen strengthened versus the US dollar in terms of London closing rates from 162.53 to 159.23. In addition, the yen gained versus the euro from 185.64 to 183.26. The BoJ at its meeting in July left the key policy rate unchanged at 1.00%, the highest level since 1995 following three 25bp hikes since January 2025.  The BoJ continues to cut JGB monthly purchases at a pace of reduction of JPY 200bn per quarter through to Q1 2027 and will then halt the reduction with monthly purchases by then falling to JPY 2trn per month.

OUTLOOK

USD/JPY plunged by five big figures on 30^th July – a standard scale of decline based on previous episodes of yen buying intervention and standard timing as well. The more notable development wasn’t the intervention itself (this was the 6^th episode since 2022 to buy yen) but the confirmation that Japan and the US conducted joint intervention for the first time since 2011 and first yen buying intervention since 1998. This is significant – each time joint intervention has happened in recent decades, it has marked a turning point in USD/JPY – in 1995, 1998, and 2011. Why now is the obvious question. We see a few possible key reasons that could prove important. Firstly, Japan sold a record USD 75bn of securities from its FX reserves in May (after the last intervention) and the US has probably grown concerned over rising yields in the US. Japan looks to have agreed to use a repo facility (FIMA) to swap UST holdings for cash rather than sell, reducing upward pressure on US yields. Secondly, Vice FM Mimura stated that FX policy would be conducted in coordination with BoJ monetary policy. This is significant and suggests a possible deal to open scope for a faster pace of BoJ rate hikes.

The unchanged BoJ policy stance in July was no surprise but following soon after the intervention there was anticipation of a more hawkish communication to reinforce the positive yen momentum triggered by the MoF. That didn’t happen. However, Governor Ueda said enough to trigger increased speculation of a sooner rate hike and the Mimura’s comment on FX/monetary policy coordination has lifted expectations further. Governor Ueda stated at the press conference that a faster pace of monetary tightening was possible (if financial conditions were too easy) so there is scope for a more hawkish shift. We are maintaining our view of a 25bp rate hike in September. Even though there was no strong signal there is scope there to make a shift, especially if energy prices move further higher and/or USD/JPY quickly recoups the drop following intervention. The BoJ continues to move to a more neutral policy setting and a faster pace is feasible under certain scenarios. 

A BoJ rate hike in September remains our call and that faster pace of tightening and this significant joint intervention certainly changes the risk-reward equation in selling the yen. The US curve is also overpriced for Fed tightening and a drop in global yields will also serve to provide additional support for the yen.

INTEREST RATE OUTLOOK

Euro

MARKET UPDATE

In July the euro advanced modestly against the US dollar in terms of London closing rates from 1.1422 to 1.1509. The ECB at its meeting in July kept the deposit rate unchanged at 2.25% - following the first hike since September 2023 in June. Balance sheet reduction continues with the ECB’s projected maturities from both APP and PEPP expected to result in a EUR 500bn decline in balance sheet holdings in 2026.

OUTLOOK

The US dollar was generally weaker in July and EUR/USD gained modestly even as Fed rate hike expectations built, in line with the re-escalation of the conflict in the Middle East and the rise in energy prices. But the move in EUR/USD over the month was relatively modest amid some concerns over the potential negative impact from the surge in natural gas prices with the front TTF contract up close to 50% in July. Higher energy prices has kept the ECB on alert, and a September rate hike is close to fully priced with another priced by March next year. For now, we continue to expect just one further hike in September, but the risks are rising of a further hike and that risk is tightly associated with the Middle East conflict and energy prices. While the ECB decision to hold in July was unanimous, President Lagarde indicated that some Governors had wondered about whether a rate hike should be considered. We already know that Chief Economist Philip Lane considers a level of 2.50% as possibly around the top-end of the neutral policy range, which further underlines the scope to hike again. A series of hikes would become justified if there was evidence of stronger second-round effects, but this evidence is yet to emerge. The ECB’s wage tracker, published in July, revealed an increase in wage growth from 2.6% in H2 2026 to 2.7% in Q1 2027. If energy prices surge again any additional Fed rate hikes priced is likely to be mirrored by the ECB.  

While we do not see grounds for any notable lurch lower in EUR/USD from here, the risks have clearly shifted and there is less compelling reason to justify EUR/USD jumping higher from here over the short-term. The intra-day low in June of 1.1325 would likely only be breached on a renewed surge in energy prices that forced the Fed to hike, which is not our current view. But our short-term valuation model for EUR/USD currently highlights downside risks. However, we maintain that Fed rate hike expectations are overdone and that the Middle East conflict is more likely to de-escalate as we approach the mid-term elections in November. That should act to create a floor for EUR/USD. For now, we see the US dollar remaining firm before depreciating more notably in 2027.

But the dollar has performed better than expected and EUR/USD is lower reflecting pricing for a rate hike. While that will not be delivered, we see scope for EUR/USD remaining around current levels for longer. We still see a higher EUR/USD but those gains are more now a 2027 development as US rates fall more notably.

INTEREST RATE OUTLOOK

Pound Sterling

MARKET UPDATE

In July the pound strengthened versus the dollar in terms of London closing rates, moving from 1.3267 to 1.3465. In addition, the pound strengthened against the euro from 0.8609 to 0.8547. The MPC at its meeting in July kept the key policy rate unchanged at 3.75%, after six 25bp cuts since August 2024

OUTLOOK

The pound strengthened versus US dollar and the euro and the BoE TWI gained a respectable 0.8%. The pound remains the best performing G10 currency after the US dollar since the conflict began although we anticipate yield could potentially play less of a role going forward. The BoE meeting in July provided the usual update of views amongst MPC members and the policy dilemma is clear – weak domestic economic conditions are proving disinflationary but are being offset by upside inflation risks from abroad related to energy and the conflict in the Middle East. If there is de-escalation and a decline in upside inflation risks, UK yields should fall and take the pound lower. If the conflict worsens and energy prices rise further, a rate hike is possible but hiking into weak domestic economic conditions is unlikely to be currency supportive. The 6-3 vote by the MPC for unchanged rates highlights the risk of a hike if energy prices remain high. Further escalation could well cause greater disruption in financial markets given the continued rise in G4 yields and higher volatility in FX and risk assets would likely coincide with pound depreciation. The UK current account deficit financing needs tends to coincide with pound depreciation during periods of market stress. Asset valuations are becoming more stretched as G4 yields continue to grind higher.

The UK 10-year Gilt real yield broke above the 2.0% level (deflated by 5y5y infl swap rate) for the first time since 2007 just before the onset of the GFC. Captured in that real yield are numerous uncertainties that contribute to the term premium. Some of that is sovereign credit risks although judging from the Gilt OIS swap spread that risk has been relatively stable. That suggests that Andy Burnham so far has done a good job in avoiding any notable jump in yields related specifically to fiscal uncertainties. But PM Burnham still has a difficult task ahead in providing low-income earners with support. The headroom from the last budget has already declined by around GBP 10bn while defence spending is already committed to rise by GBP5bn so any question marks over fiscal credibility could certainly translate quickly into Gilt volatility and renewed pound underperformance. Total headroom created in the last budget was GBP 23.8bn. A continued rise in yields from here would also add to the constraints on increased fiscal spending.

We view the UK rates market as overpriced for what the BoE delivers – currently we see the BoE staying on hold but if they hike it will still be less than currently priced (slightly more than two). The pound is therefore vulnerable to weakening and given our US dollar view that weakness will most likely be versus the euro

INTEREST RATE OUTLOOK

Chinese renminbi

MARKET UPDATE

In July, USD/CNY moved from 6.7857 to 6.7524. On 20th July, the PBoC kept the 1Y and 5Y LPR steady at 3.00% and 3.50% respectively. In mid-July, PBoC Deputy Governor Zou Lan hinted the possibility of deploying structural monetary policy tools based on market needs, and separately July Politburo meeting readout mentioned to “comprehensively use and timely adjust monetary policy tool”.

OUTLOOK

China’s Q2 GDP surprised to the downside with growth slowing to 4.3%yoy from 5.0% in Q1, coupled with lower sequential growth momentum (-0.4ppts to 0.9%qoq). Weak domestic demand from both consumption and investment dragged on overall growth by 0.4ppts each. Combined with the June macroeconomic data, the deepening K-shape growth pattern in the economy became even clearer. The readout from the July Politburo meeting showed the authorities are paying greater attention to the challenges facing the economy, but the policy emphasis for now is a quicker implementation of the existing measures. That said, they mentioned to introduce effective incremental policy measures in a timely manner, which implies that it will happen when the existing measures fail to stabilize the economy. On consumption, it continues to emphasize supply-driven approach to unleashing services demand. Looking ahead, we think the K-shape growth will likely persist, but the divergence may narrow somewhat in 2H given a faster fiscal rollout including fiscal support for “six networks” construction. In terms of long-term consumption expansion plans for the 15^th Five-Year Plan period, total retail sales of consumer goods are expected to reach RMB 60tn by 2030, implying merely an annualized growth of 3.7% from 2025 to 2030. One key highlight of the plan however was positioning housing consumption as means to boost durable goods consumption, with housing quality upgrade as a key lever.

CNY appreciation trend remained in July albeit at a gradual pace, gaining 0.5% against US dollar. Strong exports performance continued to lend support for the currency, and the release of Moonshot Kimi K3 model also reinforced the structural theme around China’s fast-rising tech capability and asset revaluation. That said, China’s equity market was not shielded from global market volatility caused by the AI concerns in July but should eventually stabilize and attract foreign equity inflow. That said, what will likely slow the pace of CNY appreciation ahead remains on the domestic growth headwind and that the latest July official PMIs showed unexpected contraction in both manufacturing and non-manufacturing activities, with new orders evidently declining. While the July Politburo meeting signalled readiness to step in with incremental measures, we expect some stabilization in near term and an overall modest growth pickup in 2H. Externally, the Fed rate path, US yields and US dollar trends continue to matter. The downside risk on CNY however lies on PBoC  delivering policy rate cuts and Fed eventually starting a rate hiking cycle, which will widen the negative yield differential with the US

INTEREST RATE OUTLOOK

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