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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

The US dollar, on a DXY basis, advanced by 2.3% in June adding to the 0.9% gain in May, closing at the highest monthly close level since March 2025. With the focus on Middle East risks receding the FX market reverted to being driven more by rate spreads, which was to the benefit of the dollar. The 2-year yield in the US closed 17bps higher whereas yields in the euro-zone, the UK and Japan either remained stable or declined. The flat to lower yields elsewhere reflected the sharper than expected decline in crude oil prices that have now fully retraced the US-Iran conflict jump. The fact that US yields still moved higher was of course down to the FOMC meeting in June and the comments from Fed Chair Warsh. There was a notable shift in the dots profile toward monetary tightening while Chair Warsh emphasised the message of the Fed ensuring it would achieve price stability. However, we would argue that the dots profile was more a reflection of the past and a dots profile done today with Nymex trading at USD 70pbl would likely be different. OIS pricing indicates 45bps of monetary tightening by March 2027 which we see as excessive.

The speed in which crude oil prices have fallen diminishes the inflation risks notably while there are other factors that will also help lower inflation. The tariffs implemented in 2025 are set to fall out of the annual CPI calculations over the coming months that will add downside pressure to annual inflation while a quirk in rental inflation should also reverse in H2. That will help ease Fed concerns over inflation risks that should see yields decline going forward. Apart from the RBNZ, no other G10 central bank has as much tightening priced as the Fed and hence there is scope for US yields to fall relative to elsewhere. This should see this recent dollar buying momentum reverse. We would also expect some renewed focus on US fiscal risks. The fiscal outlook remains dire with the IMF projecting deficits out to 2030 in the region of 7% of GDP and the mid-term elections could well result in policy gridlock that pushes addressing the fiscal problem further into the future.

The US dollar has rebounded fuelled by Fed rate hike expectations that we believe will soon begin to fade. Inflation is set to recede while GDP growth excluding AI-related activities has been subdued. Consumer confidence remains around covid-lows that highlights vulnerabilities. Fiscal risks coming back into focus as yields decline will encourage renewed hedging of US assets and weigh on the dollar.

OUTLOOK

The US dollar, on a DXY basis, advanced by 0.9% in May, partially reversing the drop in April as the dynamics in the FX market started to change. Brent crude oil and risk became less influential in driving the US dollar and there was a shift back to the more traditional driver – rate spreads. This was prompted by the jump in US yields as investors reassessed the Fed policy stance and considered the need for monetary tightening given the continued rise in inflation pressures. The 2-year UST bond yield jumped by 13bps in May whereas in Europe, the 2-year yield dropped by 11bps and the UK the drop was a larger, 24bps. US yields basically played catch-up from underpriced risks of hikes while in Europe investors viewed hiking as overpriced. The risk now is that the momentum higher for yields in the US could reverse if this reported US-Iran deal is confirmed and energy prices fall further. That said, we do not expect initial big moves. Brent crude oil is already close to 20% down in just two weeks and hence much of the good news associated with a deal is priced.

While the argument put forward of the need for a rate hike in the US remains unconvincing in our view it is clear that the debate on Fed policy has shift from no change or a cut to no change or a hike with most comments from Fed officials now assessing the risks between a hike or no hike. The FOMC minutes from the April meeting indicating broadening support for the implied easing bias to be dropped and a growing view that a hike would be needed if inflation remained elevated. However, we should not underestimate the potential influence of Fed Chair Warsh. He is known to favour trimmed measures of inflation as a more accurate measure of underlying inflation conditions and the Dallas Fed Trimmed Mean YoY CPI rate fell to 2.3% in April – the measure has been stable around this level for three months and the lowest since August 2021. If a US-Iran extended ceasefire deal is agreed, then Warsh will push this view harder and that will likely result in the rates curve removing the current pricing of a risk of hikes back to the potential for easing.

US inflation data is likely to show a pick-up in the coming months but happening in the context of a 60-day deal extension and the reopening of the Strait of Hormuz will allow Fed officials to look through this and focus on potential downside risks to growth. We see that approach as reinforcing downside risks for the US dollar and hence we are maintaining our bearish outlook for the dollar over the forecast period.

INTEREST RATE OUTLOOK

Japanese yen

MARKET UPDATE

In June the yen weakened versus the US dollar in terms of London closing rates from 159.15 to 162.53. However, the yen strengthened marginally versus the euro from 185.93 to 185.64. The BoJ at its meeting in June raised the key policy rate by 25bps to 1.00%, the highest level since 1995 and the third 25bp hike since January 2025.  The BoJ also confirmed it would continue cutting JGB monthly purchases at a pace of reduction of JPY 200bn per quarter through to Q1 2027 and would then halt the reduction with monthly purchases by then falling to JPY 2trn per month.

OUTLOOK

The yen weakened further in June with USD/JPY breaking above the intervention levels from April/May and above the recent high of 161.95 to trade at levels not seen since 1986. The record JPY 11.7trn worth of yen selling by the MoF has come to very little in terms of strengthening the yen but it could be argued that it continues to play a role in deterring yen selling at these levels. The MoF has been less vocal on threatening intervention in recent weeks but Finance Minister Katayama on 30^th June repeated that Japan and the US are aligned on FX policy, implying support for further intervention if required. Katayama’s explicit threats to intervene are now having little impact. The US 2-year yield closed 17bps higher in June following the hawkish FOMC meeting and the MoF may well be more accepting of further yen weakness at least until the global backdrop becomes more aligned to a weaker US dollar. It is our view that this will happen given we see the next Fed move to be a cut. The sharp decline in crude oil is also yen supportive from a terms of trade perspective.

As expected, the BoJ hiked its key policy rate by 25bps in June, but the action failed to deter yen selling. The communication from the BoJ suggested a continued pace of raising rates every six months and this is deemed too cautious to provide support for the yen. We see a growing risk that the BoJ may need to up the pace of rate hikes, and hikes in September and December is an increasing risk. The BoJ communications in June did point to an increased upside inflation risk which without response helps to fuel yen selling as expectations increase of yields remaining lower for longer in real terms. A more active BoJ would also help dispel the belief amongst investors that the Takaichi government is holding the BoJ back from hiking. There were reports by Bloomberg at the end of June that a government economic policy document set for release in July would include a call for “appropriate” monetary policy – a suggested hint for continued BoJ caution. Inflation is set to pick up again after falling below the 2.0% target. The BoJ forecasts the nationwide core CPI to reach 2.8% this fiscal year. That could be raised further given the upside risks. 

If US yields fail to decline and expectations of a BoJ rate hike in September remain low (5bps priced currently), then USD/JPY could keep moving higher with the MoF reluctant to continue intervening. We do ultimately see US yields falling from current levels which coupled with further BoJ rate hikes will prompt USD/JPY to fall.

INTEREST RATE OUTLOOK

Euro

MARKET UPDATE

In June the euro weakened against the US dollar in terms of London closing rates from 1.1683 to 1.1422. The ECB at its meeting in June raised the deposit rate by 25bps to 2.25% - the first hike since September 2023 when the ECB completed its tightening cycle following the global inflation shock. Balance sheet reduction continues with the ECB’s projected maturities from both APP and PEPP expected to result in a EUR 500bn reduction in balance sheet holdings in 2026

OUTLOOK

The euro weakened versus the US dollar further in June with expectations of additional rate hikes from the ECB diminishing. We did not expect to see Brent crude oil prices falling as rapidly and assumed there would be a more substantial geopolitical risk premium throughout the remainder of 2026 which would have resulted in an inflation level that prompted the ECB to hike again. That view is certainly in doubt if crude oil remains at these levels or obviously fall further. Prior to the ECB rate hike in June, the OIS market was close to pricing three rate hikes and now roughly one hike is priced – so a rate hike has been removed fuelled by the sharp decline in crude oil prices following the ceasefire extension deal. The drop in crude oil and some of the inflation data do suggest that second-round inflation risks are less than feared. We did not expect the ECB to hike on three occasions in any case and still view one further rate hike as feasible although the risks have certainly shifted to the potential of no additional rate hikes. However, ECB Chief Economist Philip Lane did state that the top of the neutral policy range had likely drifted higher to 2.50%, which implies there being limited risk to one further rate hike to provide insurance. The ECB 1-year inflation expectation reading fell from 4.0% in April to 3.5% in May, below the consensus. However, the 3-year level remained at 2.9%, slightly above the market consensus.  

As we have highlighted before, the reduced concerns and focus on the US-Iran conflict and the sharp drop in crude oil prices have seen the gradual importance of rate spreads for FX increase. Relative macro has been revived as a driver of FX. The 2-year EU-US swap spread fell sharply in May and modestly further in June as excessive rate hike pricing was removed from the curve in Europe. If crude oil prices remain around current levels, we would conclude that pricing for a Fed rate hike is more unrealistic than an ECB hike and would assume the spread has scope to move back in favour of a retracement higher in EUR/USD. ECB rhetoric implies reduced risk of a hike but given the ECB has hiked, it remains plausible that a further insurance hike is delivered.

EUR/USD has now traded below the 1.1500-level for the longest period since June last year but we do not see this as a signal of a sustained move lower. Yield spreads have become a more important driver of FX again and we expect EUR/USD to recover as Fed rate hike expectations recede while the ECB hikes one last time

INTEREST RATE OUTLOOK

Pound Sterling

MARKET UPDATE

In June the pound weakened versus the dollar in terms of London closing rates, moving from 1.3481 to 1.3267. However, the pound strengthened marginally against the euro from 0.8666 to 0.8609. The MPC at its meeting in June kept the key policy rate unchanged at 3.75%, after six 25bp cuts since August 2024.

OUTLOOK

The pound weakened versus the US dollar but strengthened versus the euro and was close to unchanged on a BoE trade-weighted basis. In fact, after the US dollar, the pound was the next best performing G10 currency in June and indeed over the period since the Middle East conflict began at the end of February. Yield support helped explain that performance earlier during the Middle East conflict but not in June with the pound performing better relative to yield spread moves versus the dollar and euro. The lack of evidence of inflation feed-through from energy may be helping investor confidence although that risk will linger over the coming months. The exceptional low levels of volatility also tends to help support the pound, which usually performs poorly during periods of market stress, given the UK’s external funding needs due to the current account deficit. There may also finally be some signs after years of negativity (post Brexit) that investors see value in UK assets. Bloomberg reports nearly GBP 50bn of inbound M&A deals on a year-to-date basis. Buyers have paid a 35% average premium for UK-listed companies this year.

We have changed our call on BoE rate hikes from expecting two hikes to remaining on hold following the last two CPI data releases that were weaker than expected. In addition, the speed of decline in crude oil prices also provides capacity for the BoE to remain on hold. While lower yields are generally FX negative, in the case of the UK with policy already mildly restrictive, the reduced need to monetary tightening reduces downside growth risks and is providing support for the pound. Ever since Brexit, the UK has been viewed as a country with higher inflation risks. The lack of inflation so far since the start of the Middle East conflict may well be helping to reverse years of declining investor confidence (also seen by M&A developments).

The improved inflation backdrop is helping to deter Gilt market selling on political uncertainties. Andy Burnham looks set to become PM following PM Starmer’s resignation and so far, this change in leadership has not prompted fiscal concerns. Andy Burnham appears to be more focused on reforms, like further devolution and reduced red tape to reinvigorate housing construction. Burnham has also promised “discipline of the current fiscal rules”. We assume limited political instability.

Much of the recent GBP/USD moves have been USD-driven with the pound broadly stable. Given our US dollar bearish view is being maintained we expect the pound to advance versus the dollar while we have lowered the upside scope for EUR/GBP based on the receding risks related to the conflict in the Middle East.

INTEREST RATE OUTLOOK

Chinese renminbi

MARKET UPDATE

In June, USD/CNY moved from 6.7658 to 6.7857. On 22nd June, the PBoC kept the 1Y and 5Y LPR steady at 3.00% and 3.50% respectively. The PBoC introduced the overnight reverse repo operation as a new monetary policy tool on 29th-30th June, with the operation volume disclosed but not the interest rate.

OUTLOOK

China’s economy weakened further in May from April, with softness broadening across domestic demand, reaffirming the “two-speed” nature of the economy as exports and industrial production remained resilient. In particular, the FAI contraction became more pronounced, with YTD growth slumping to -4.1%yoy in May as infrastructure investment slowed and manufacturing investment unexpectedly contracted, the first decline since the Covid period. Similarly, retail sales also weakened, with demand for big-ticket items remaining soft but staple goods growth holding up, highlighting persistently weak household confidence. The weakness in demand was also reflected in May CPI inflation, with core inflation edging down to 1.1%yoy, suggesting limited spillover from higher energy prices. Household deleveraging remained evident, with loan balances contracting for a second consecutive month in May, reflected in both short-term and longer-term borrowing. While tech-related exports and industrial production continue to demonstrate resilience, the broader economic slowdown cannot be fully offset by these sectors alone. On the other hand, the latest June official PMIs showed a modest pickup in manufacturing (+0.3ppts to 50.3) and services activity (+0.1ppts to 50.4), although we remain cautious regarding the pace of any recovery in domestic demand. The Politburo meeting in April launched the “Six Networks” initiative, establishing a unified infrastructure priority for the upcoming 15th Five-Year Plan period, covering water, power grids, computing, next-generation communications, urban pipelines and logistics. This initiative serves as a large-scale investment and stimulus engine that supports demand, employment and industrial activity in the near term, while enhancing productivity over the medium to longer term. It is estimated to generate RMB7tn of investment this year (around 14% of 2025 FAI).

The CNY was resilient in June weakening only modestly (0.3%), despite the broader 2.3% dollar gain. A hawkish Fed repricing, higher US yields, resilient US data dominated the Dollar’s movement, despite the decline in oil prices. Looking forward, these external factors, together with domestic developments including the July Politburo meeting, will be the main drivers for USD/CNY movement. We also expect more clarity from the July Politburo on policy supports for the economy in near term, and more information on the road map of investment activities of the “six networks”. These likely anchor a mild strengthening bias for CNY against the dollar. With the market still trying to figure out Fed’s potential new framework, it is likely to see some increased policy uncertainty and volatility in US dollar and Asian currencies, having said that, the CNY likely remains relatively resilient compared with Asian peers.

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