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As the Federal Reserve remains as the only major central bank currently looking to hike rates (with December seen as a distinct likelihood) USD remains fundamentally the strongest currency of all the majors and therefore should ultimately strengthen against its counterparts. However, USD sentiment and short-term price action will largely be determined by economic data, rhetoric from the central bank, and its influence on rate hike expectations.

USD strength - counterpart weakness

Traders must also keep in mind the fundamentals affecting other major currencies when trading USD. The greenback is certainly likely to experience continued strength against GBP, JPY and NZD.

GBP

The GBP is likely to remain fundamentally weak for the foreseeable future especially considering current expectations for a further rate cut in November. UK data has however been stronger than many economists had expected and should UK data continue to surprise, expectations for further easing may reduce and see GBP continue its recent retracement.

JPY

At their September meeting, the Bank of Japan left interest on excess reserves unchanged at -0.10% and QQE at 80 trillion JPY. In the accompanying comments, the BoJ stated that they are to ‘introduce yield curve control’ and ‘to abandon monetary base targets’. This essentially means that the BoJ will place its attention on raising the 10 year yield curve of Japanese Government Bonds to 0.0% with shorter term yields remaining at around -0.10%, instead of targeting a monetary base target of 80 trillion JPY. In theory by steepening longer term yields compared to shorter term yields bank profitability should increase which in turn should lead to greater levels of banking activity, which should lead to greater levels of economic activity and therefore higher levels of inflation. The central bank went on to state that they would ‘maintain a commitment to reach 2% inflation as soon as possible’ and ‘may speed up the expansion of monetary base as future policy option’.

Although fundamentally JPY is a bearish currency as inflation continues to decrease and the BoJ reaffirming its willingness to ease further in order meet its 2% inflation objective; JPY will continue to remain attractive as a safe haven currency and therefore will remain well supported and strengthen during times of uncertainty/risk-off sentiment. However, we should expect continued weakness against USD.

NZD

The NZD has been pressured in recent sessions as risk sentiment has started to present a more risk-off tone resulting in weakness in equities, commodities and commodity based currencies. Due to NZD also having the highest interest rate of all the majors, during times of ‘risk-on’ yield environments NZD generally remains well supported. However, during times of uncertainty or risk off typically becomes further pressured.

Although the Reserve Bank of New Zealand will likely need to cut interest rates further in the future, recent rhetoric has suggested this may not be as soon as many analysts had expected. Furthermore, considering inflation remains the primary argument for further cuts, the likelihood is the RBNZ will wait until Q3 inflation is released in October before making any further adjustments. Given the next rate cut is therefore not expected until November - and the RBNZ still maintain the highest interest rate of the major central banks - NZD is likely to remain supported during risk-on environments through carry trades, as it is brought against those currencies with extremely low or even negative interest rates. Nevertheless, we would ultimately expect NZD to weaken against its fundamentally stronger counterparts - such as USD.

Jarratt Davis
FX trader, Funds Manager and Mentor
Author of How to Trade a Currency Fund

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