We are in the last innings of the dollar's surprise rally.
Investors require a higher yield or a weaker currency to compensate for the risk of trade and fiscal deficits following the Trump tax cuts. Coming into April, investors deemed the compensation was sufficient. As the American economy outperformed the rest of the world, particularly Europe, the U.S.'s yield advantage widened further. Rates and FX are now in sync again as they both reflect economic strength.
For the dollar to keep rallying, the yield spread needs to widen further. In other words, the U.S. has to power ahead while other economies struggle. But Fed expectations are reasonably priced for this year, so for the dollar to rise, yields elsewhere need to fall.
For USD/JPY, the implication is straightforward. Stalling U.S. yields and BOJ's curve control mean 110 is pretty much as high as it gets for the pair.
EUR/USD could be bottoming. The Fed is willing to tolerate a small temporary inflation overshoot, while the ECB is willing to overlook some economic weakness as they think it could be transitory. The market is in the "I'll-believe-it-when-I-see-it" mode. But if the ECB is right, when the data stabilizes and starts to pick up will be the time for the EUR/USD to shine again.
Source: Bloomberg Pro Terminal
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