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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 August the US dollar weakened further against the euro in terms of London closing rates, from 1.1509 to 1.1598. However, the dollar strengthened against the yen, from 159.23 to 160.03. The FOMC did not meet in August and hence the range for the federal funds was unchanged at 3.50%-3.75%. 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 depreciated in August, on a DXY basis the drop was 0.5%, driven primarily by the decision of the US Treasury to announce an increase to the scheduled buybacks of longer-term UST bonds. Understandably that triggered concerns of yields being distorted lower that resulted in an immediate drop in the dollar. Given this followed the decision to join Japan in buying the yen that was again related to keeping US yields lower (reducing Japan’s need to sell UST bonds to finance USD sales) investors are being given the impression of growing concerns in Washington over rising yields. Of course, without addressing the underlying reasons for rising yields (fiscal outlook and Fed’s reaction function in fighting inflation), yields could remain under upward pressure. Attempts to cap yields without addressing the fundamental factors behind the move does not instil confidence amongst global investors and the prospect of fiscal consolidation ahead of the mid-terms or even through the remainder of Trump’s term in office remains very low.

However, the US dollar debasement theme did not last too long with rising yields ultimately helping to provide support for the dollar. Pricing for a rate hike by the Fed in September jumped from about 35% to 60% following Warsh’s Jackson Hole speech. His comment that the Fed has “work to do” if inflation doesn’t move to the 2% inflation target “with sufficient speed” and his acknowledgement that financial conditions are not restrictive clearly points to an increased risk of a 25bp rate hike in September. There will be some uncertainty that will persist given there is another NFP and CPI data release before that meeting, but we now would likely need to see another weak NFP and CPI print and some further retracement of energy prices to provide the justification not to act. The decision to hike in September now looks like a very close call and a lot must go the same way for the Fed to remain on hold.  

The decision to hike, if it happens, is unlikely to be a gamechanger for the dollar. Developments abroad also point to other central banks being more hawkish than we initially expected. A third rate hike from the ECB is becoming a bigger risk, a hike by the BoE, the RBA and Norges bank (all not fully priced) are possible either in September or by year-end and hence rate spreads are unlikely to move dramatically in favour of the dollar. We’d also assume it more likely than not that a Fed hike could prove a one-off based on our view of a decline in energy prices, weak jobs and CPI.

INTEREST RATE OUTLOOK

Japanese yen

MARKET UPDATE

In August the yen weakened modestly versus the US dollar in terms of London closing rates from 159.23 to 160.03. In addition, the yen weakened versus the euro from 183.26 to 185.60. The BoJ did not meet in August and hence the key policy rate was 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

Intervention to buy the yen in late New York trading on 31^st July saw the yen extend gains at the start of August but USD/JPY quickly retraced and August was more about stability with the range of 158.00-159.00 holding from 10^th August until the final two days of the month. Joint intervention matters but policy matters more and doubts continue to linger on whether this joint action will lead to any coherent shift in economic policy in Japan. PM Takaichi is viewed as having a strong bias favouring a reflationist approach and hence concerns over the fiscal policy outlook is deterring a more notable gain for the yen. The near-term energy risks are likely also playing a role in limiting demand for the yen. After the start of the US-Iran conflict Japan turned to its oil reserves and energy imports in the period March to May remained relatively subdued. However, mineral fuel imports have surged with the July fuel import bill 60% higher than the average monthly bill between March and May.

At the end of August the OIS market implied a 90% probability of a rate hike at the next meeting in September. By mid-2027 the market now expects the BoJ policy rate to reach 1.75%, perhaps around the mid-point of the previously cited R* range of between -1.0% and +0.5%. Deputy Governor Himino gave a speech and despite offering no explicit guidance on a hike was clearly on the hawkish side and effectively endorsed current market pricing. But the issue for the yen is the speed of getting to neutral and given it is so drawn out – at least another year based on current pricing – there is a perception amongst investors of a reluctance to lift rates to that level or even an ability to do it given the implications on the cost of servicing Japan’s debt. That uncertainty raises fears over ‘fiscal dominance’ – when monetary policy is dictated not by the inflation outlook but by the constraints of the debt burden. So the quarterly pace of hiking (June/September) is not priced to continue and that reflects to a degree the continued caution of the BoJ. The BoJ forecasts core nationwide CPI at 2.4% in FY2027 while the OIS market implies a policy rate of 2.25% in two years pointing to a negative real policy rate over all that period.

A BoJ rate hike in September is nearly fully priced and two further hikes by mid-2027 are also priced. Hence action in September won’t be a big driver of yen strength. For USD/JPY the removal of the Fed tightening priced in the curve will help USD/JPY move lower, but Japan factors will contain the extent of any move lower

INTEREST RATE OUTLOOK

Euro

MARKET UPDATE

In August the euro advanced further against the US dollar in terms of London closing rates from 1.1509 to 1.1598. The ECB did not meet in August and hence the deposit rate was 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 again in August and EUR/USD gained further on the back of renewed focus on US dollar debasement fears. The euro as the most liquid alternative to the dollar benefits by default. However, the euro was the fourth best performing G10 currency in August and advanced on a trade-weighted basis as well, by 0.7%. The ECB’s EUR EER reached the highest level since May. What became more apparent in August was the improvement in sentiment despite the continued risks related to the Middle East and energy prices. The German IFO Business Climate Index jumped more than expected (86.7 to 88.8) – the index has more than fully retraced the drop after the conflict began and reached a level not seen since August last year. Natural gas prices need monitoring given the risk of gains hitting growth and confidence but more tanker traffic through the Strait of Hormuz is helping contain prices for now. However, TTF natural gas gained 20% in August after a 33% gain in July. German grid operators stated in August that the winter gas storage target was “virtually unattainable”. Storage as of 24^th August was 63% of capacity vs a 5yr average of 81%. The improvement in the economic outlook while inflation risks persist was enough for ECB Executive Board member Schnabel to state that “further tightening will be necessary”. The OIS market is now nearly fully priced for a September hike and 80% priced for two 25bp hikes by year-end. We expect one but increasingly see the risk of the ECB delivering another.

Political uncertainty in Europe will remain elevated over the coming year, notably ahead of German state elections in September and the French presidential election in April 2027. While strong performances by anti-establishment parties could generate bouts of volatility and renewed scrutiny of fiscal policy, recent experience suggests that lasting FX effects require a meaningful change in the policy outlook. For now, we see limited evidence that upcoming elections will materially alter the euro area's macro outlook. The AfD could win strongly in the Saxony-Anhalt state election on 6^th September, which would further undermine the Merz government.

Consequently, while political developments warrant close monitoring, we continue to believe that EUR direction will be determined primarily by relative growth and interest rate expectations rather than electoral outcomes. Recent signs of economic resilience and the continued willingness of the ECB to respond to upside inflation risks will continue to provide support for EUR/USD.

INTEREST RATE OUTLOOK

Pound Sterling

MARKET UPDATE

In August the pound strengthened versus the dollar in terms of London closing rates, moving from 1.3465 to 1.3556. However, the pound weakened marginally against the euro from 0.8547 to 0.8556. The MPC did not meet in August and hence the key policy rate was 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 an additional 0.5% after a 0.8% gain in July. The pound remains the second best performing G10 currency since the Middle East conflict began at the end of February. The UK economy continues to hold up better than expected and this economic resilience is not feeding into higher domestically generated inflation concerns at this juncture. Real GDP in Q2 expanded by 0.4% Q/Q following a 0.6% expansion in Q1 – the strongest performance since the first half of 2024. Momentum going into Q3 was also solid with the MoM increase in June a strong 0.3%. That gain was driven by a 0.4% gain in services. Services looks to have remained resilient in Q3 with the PMI services index in August increasing to 52.8, the strongest level since February.

The resilience is not translating to increased investor concerns over inflation. YoY CPI in July increased as expected due to the OFGEM utility bill price cap but there were no underlying upside surprises and the evidence of domestically generated inflationary pressures remain sparse. OFGEM confirmed a 4% further increase effective October, which was very close to the BoE estimate assumed in its inflation projections published in July. PAYE employment fell 13k in July and underlying private sector wage growth (3mth YoY) slowed to 2.8% in June – excluding the covid period, that increase was the weakest since June 2018 and the 16^th consecutive month of slowing annual growth. That is compelling reason to hold off hiking if the external inflation risks subside. The external risks remain of course but crude oil prices gained only 0.4% in August indicating scope for the BoE to stay on hold. The BoE remaining on hold this year will likely see a notable decline in front-end yields.

The 12mth OIS implied 70bps of tightening and would leave the UK with the highest official policy rate in G10. We suspect this pricing is excessive and will adjust lower as domestically generated inflation remains subdued and energy risks subside. PM Burnham’s honeymoon period looks to be coming to an end and the fiscal constraints on adopting any meaningful policy initiatives to support economic growth could raise fears of steps that lack fiscal credibility.

The pound continues to outperform relative yield changes and based on EZ-UK 2yr spreads, EUR/GBP should be trading between 0.8800-0.8900. Better economic growth and weaker inflation has helped improve investor confidence. Still, with GBP/USD already at our 12mth forecast (1.3640) we have adjusted our GBP forecasts slightly stronger but still assume some correction weaker initially

INTEREST RATE OUTLOOK

Chinese renminbi

MARKET UPDATE

In August, USD/CNY fell from 6.7524 to 6.7272. On 20th August, the PBoC kept the 1Y and 5Y LPR steady at 3.00% and 3.50% respectively. The Q2 PBoC Monetary Policy Implementation Report released in mid-August provided little new policy guidance, largely echoing the July Politburo meeting's call to "comprehensively utilize and timely adjust monetary policy tools" without further details.

OUTLOOK

The Chinese economy continued to lose some steam in its growth momentum in July following a below-target Q2 GDP growth, as the strength in exports/high-tech industries and somewhat accelerated government bond issuance failed to offset the broader weakness in domestic demand. Nearly all major activity indicators for July including IP surprised to the downside although extreme weather was partly to blame. The softer print in core CPI inflation since May is also concerning. Overall, the “K-shape” dynamics are likely to persist through the rest of this year, though we expect a faster pace of government bond issuance to boost infrastructure investment particularly in “six networks” related projects to stabilize growth. Remaining 44% of annual bond quota or RMB 6.1tn of funds are to be deployed for August-December period. While the main policy focus remains on expediting the rollout of existing policy measures, the authorities have signaled their willingness to step up the support if needed. The MoF announced the plan to unveil additional fiscal-financial coordination policy measures in 2H and will consider incremental policy measures depending on economic condition. At the same time, they also introduced optimization of the fiscal-financial coordination policy to support domestic demand, benefiting both small private businesses and consumers through broader scope of loan/ credit card installments subsidy eligibility and higher subsidy caps.

The weakness in the July macro data did not deter CNY from further appreciating albeit modestly in August, helped by the weaker dollar backdrop and strong exports/ trade balance. That said, CSI 300 performance was rather range bound as tech sentiment recovery was offset by weaker prospect of China’s economy. As such, a solid domestic demand/ earnings recovery will be helpful to further attract foreign equity inflow in addition to the structural theme around China’s AI tech. While China suffered some foreign equity outflow in June-July period (net USD 18bn) given the global tech volatility, the IIF data showed a total USD 37bn net foreign inflow into China’s equity during first 7-months this year (whereas the rest of EM Asia on aggregate suffered net outflow).  The CNY could strengthen modestly in September as China's trade surplus remains sizeable and export performance continues to provide a steady source of FX inflows. In addition, any moderation in US dollar strength or Treasury yields would help narrow external pressures on the renminbi, allowing for gradual appreciation while policymakers maintain overall currency stability.

INTEREST RATE OUTLOOK

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