International developments & the U.S. dollar
Global markets have been in turmoil recently since Japan raised its interest rate and moved to positive territory. The Bank of Japan has continued its hawkish rhetoric despite market volatility. The fundamental element for the Japanese economy has not changed though and interest rate hikes in Japan are long overdue. The main reason for the global market volatility is rather the yen carry trade, a popular investment strategy that exploits the gap between extremely low Japanese interest rates and high rates elsewhere, predominantly the U.S.
A more aggressive Bank of Japan combined with soft U.S. economic data have threatened to narrow the gap between Japanese and U.S. interest rates, prompting an unwinding of the trade. The trajectory of the U.S. economy is likely to play a critical role in the future value of the yen and, subsequently, the future of the carry trade. Further deterioration in the labor market or other evidence of an economic downturn could prompt the Fed to move aggressively on interest rates, subsequently weakening the dollar and fueling the unwinding of more trades.
The outlook for global GDP growth has softened modestly, and the forecast growth is 2.9%. In particular, China’s economy slowed meaningfully in the second quarter, with consumer spending a noticeable area of underperformance. Continued disinflation pressures, a real estate sector that remains in correction and the trend toward China becoming a less integral part of the global supply chain are all factors that could weigh on Chinese activity. In the absence of large scale fiscal stimulus, the GDP forecast a further moderation in Chinese growth, 4.8% in 2024 and 4.5% in 2025.
While the U.S. outlook has seen only modest revisions, we do expect growth to slow over time, and a softer economic growth in Mexico is also expected. The United Kingdom is an exception to the softer global trend despite a shaky start from the new government with social unrest and nationalization plans. Improving real income trends along with firming activity and sentiment data have prompted a forecast lift for 2024 U.K. GDP growth forecast to 1.0%. This is of course a very modest growth from a low starting point, and the U.K. is still an economy and a country in decline. Some observers even call it the sick child of Europe and the new Labour government has not improved this image so far.
From a global perspective, while the outlook remains for reasonably resilient growth in activity, downside risks appear to be growing. In contrast to the outlook for more aggressive Fed easing, it is worth noting the outlook for foreign central bank monetary policy. Given still-elevated wages and lingering inflation concerns in many regions, including among others the Eurozone, the U.K., Australia and New Zealand, one can continue to expect relatively gradual easing from those central banks. That said, Canada is the one major central bank where faster easing than previously is expected with an anticipated 25 bps rate cuts at the remaining three meetings this year, which would see the policy rate end 2024 at 3.75%. This faster easing stems from contained Canadian inflation trends, as well as the country’s economic linkages to the U.S.
On the flip side, the Bank of Japan raised its policy rate to around 0.25% at its late July meeting, as it seeks to normalize monetary policy amid firming wage growth while inflation stays elevated. It is forecasted that further Bank of Japan rate hikes will follow in October and January, although whether that Bank of Japan tightening transpires could depend on the extent of U.S. economic slowdown and how aggressive the Federal Reserve is in lowering interest rates.
While a faster pace of Fed monetary easing should weigh on the U.S. dollar to some extent, should that occur against a backdrop of slowing global growth and unsettled financial markets, there would likely also be some safe-haven support for the U.S. currency. The view remains for gradual overall U.S. dollar depreciation through the end of 2025, but if the U.S. economy continues to show resilience and outperform other major economies, the U.S. dollar will remain dominant.
The U.S. dollar can even appreciate should global geopolitical conflicts escalate, in particular in Europe and the Middle East. The U.S. election in November could also result in global economic volatility as the two presidential options have vastly different agendas. The U.S. is quite well positioned for an economic slowdown as it has space to reduce the relatively high interest rate to jump-start the economy if needed. Other countries have less options and flexibility.