The USD has emerged as one of the biggest losers from the recent shock CNY devaluation. The recent USD losses were particularly pronounced against the ‘funding’ currencies – EUR and JPY. This development highlighted the importance of risk-aversion as an FX driver that, at times, has a stronger impact on the USD-crosses than other factors like policy divergence. Indeed, the correlation between risk-aversion and USD has shifted dramatically, with the USD increasingly behaving like a high-beta rather than safe-haven currency
Looking ahead, we expect risk-aversion to play an important role as driver of G10 FX markets as Fed lift-off draws near. The outperformance of USD against EUR and JPY on the back of growing Fed tightening bets and persistent dovishness of the ECB and the BoJ should thus continue to be punctuated by spikes in risk-aversion
We do not believe that the current developments in China will lead the Fed to change its policy outlook for higher rates this year. In addition, falling inflation expectations in the Eurozone and Japan coupled with undesirable FX appreciation could bring forward policy action (QE and/or verbal intervention) by the BoJ and the ECB.
We suspect, however, that investors have been too quick to scupper the policy divergence trade and sell USD against the ‘funding currencies’ EUR and JPY.
The decoupling trade could resume before long and support USD in coming months. Our econometric analysis further suggests that the relative policy outlook has been the dominant driver of EUR/USD and USD/JPY in recent years and that risk-aversion had only a secondary, and often transient, statistically insignificant impact.
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