USD shorts could be set for a nasty reality check if the US economy remains resilient and core inflation remains sticky, possibly engaging both sides of the “USD smile” that drive USD strength.
The USD smile is a phenomenon observed in the forex markets, where the USD has the potential to outperform other currencies under two radically different scenarios. This often occurs where there is a risk off appetite from investors, who will buy USD, but also where there is optimism about the strength of the US market specifically, and where domestic US markets are going well.
“The banking turmoil was a milestone pointing in the direction of further tightening on credit that will eventually lead to an economic slowdown, but it looks like “eventually” will prove much further over the horizon than we anticipated,” said John Hardy, Head of FX Strategy at Saxo.
According to Hardy, in Q3, it is Saxo’s belief is that markets are overconfident in benign outcomes for inflation and therefore for central bank policy. This could engage either or even both sides of the USD smile.
“With global risk sentiment in near euphoria as of late Q2, we are watching the 10-year US Treasury benchmark, which would threaten a reality check and boost the USD as well as a move to new cycle highs,” Hardy said.
Is the JPY market going to calm down in Q3?
Another market of particular interest is Japan. The Bank of Japan’s (BoJ) easy monetary policy is likely one of the key pillars helping to support strong global liquidity and positive risk sentiment that has seen markets rebounding so aggressively following the March turmoil, especially on enthusiasm for Japanese equities.
Curiously, as of late June, implied options volatility and options skew in JPY suggest a retreating belief in the potential for any JPY volatility. Saxo said that the JPY is the most stretched of all currencies in value terms, and if the bond market is wrong about the cycle, the market could prove wrong in driving the JPY lower on the risk of a BoJ dam break.
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