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We are witnessing the dying embers of a USD rally that once burned so bright, and we may be on the cusp of a weakening USD trend. The baseline view is that once the hawkish consensus falters the USD will weaken.
"The market is already questioning economists' and Fed members' hawkishness, but if at any stage this hawkishness falters, it will have negative implications for the USD, in our view. Our analysis of post-crisis central banking illustrates that many tightening cycles ended early and reversed, with a negative impact on various currencies", says HSBC.
The complication for the Fed is that the FX impact beyond a weaker USD will vary depending on the catalyst for a truncated cycle. If rate hikes are halted due to poor growth then a "risk off" world is most likely - a world where the USD performance is mixed, and where developed market FX outperforms emerging market FX. However, if rate hikes are halted due to low inflation then we should go back to a 'risk on' world, with many EM currencies likely to capitalise.
"We believe there is excessive optimism on the USD, especially against G10 currencies. Having seen the end of the USD bull run against developed market currencies, we could now be on the cusp of a weakening USD trend. The upcoming US tightening cycle could be unconventionally brief, confounding USD bulls relying on the US Federal Reserve to deliver a more aggressive series of rate hikes than is currently priced in", added HSBC.
