UFG expects the dollar to strengthen in the short term as the Federal Reserve tightens policy and markets further adjust expectations.

“Since November, the federal funds rate has largely been in the 1.75% – 2.00% range, but if there is now a break above to move towards the Fed’s 2.50% forecast, this is likely to provide further support for the US dollar.”

According to the bank, there are still reasons to remain cautious about the degree of US dollar strength.

First, MUFG expects strong global GDP growth this year, which will support asset prices and limit US demand.

The bank also notes that there are a lot of long dollar positions in the market and that the US dollar is too strong: “Valuations across most of the G10 show that the dollar is overvalued and against some currencies (JPY, SEK, NOK) the overvaluation is around 20%.”

MUFG doubts there is significant scope for continued yen weakness despite widening yield spreads, as the Japanese currency is significantly undervalued.

“We still see some scope for moderate further weakening, but valuation metrics point to extreme undervaluation, which in our view means the scope for sustained yen weakness is limited.

Historically, the USD/JPY pair usually peaks at the time of the first rate hike and then weakens over the next 6-12 months. “The USD/JPY exchange rate is forecast to peak at 117 and then retreat.

MUFG remains skeptical of the euro’s near-term prospects, but sees scope for medium-term improvement, “there are developments that point to an improved outlook for the euro in the medium term.”

He notes that French President Macron and Italian Prime Minister Draghi are pushing for more fiscal spending. According to MUFG, “This is probably still a long way from materializing, but it is a sign of a shift towards a greater focus on avoiding fiscal constraints on growth. We also expect the very negative backdrop of cross-border flows to improve.”

Stronger macroeconomic data will gradually support the single currency:

“For now, pressure on the euro will remain, but if macroeconomic conditions in the euro area continue to gradually improve and fiscal policy helps to support growth, we see grounds for the euro to recover in the second half of the year. “The euro to dollar (EUR/USD) exchange rate is forecast to hit a low of 1.10 before recovering to 1.16 at the end of the year.

Bank of England expectations may be lowered

MUFG doubts that the pound will receive underlying support from the Bank of England’s actions, given the degree of policy tightening already embedded in the price:

“With over 120bp of tightening embedded this year, we see the possibility of a partial pullback, which would initially put pressure on the pound’s momentum.”

The bank also doubts that the Bank of England will engage in a prolonged tightening cycle.

“We believe more action from the Bank of England with an additional 25bp rate hike in May will support the pound against the euro, but later in the year the risks of a slowdown could cause the Bank of England to pull back and lead to a reversal in the pound against the euro.”

MUFG has revised its forecasts for the Pound slightly downwards, with the Pound to Dollar (GBP/USD) exchange rate having only limited upside potential later in 2022 as the Dollar loses ground.

Trading momentum for the Canadian dollar

MUFG expects only limited support for the Australian Dollar from the Reserve Bank’s change in stance towards higher interest rates, given that market yields have already risen.

The Bank also expects global monetary tightening and weakening equity markets to act as a near-term headwind: “Uncertainty will weigh on the performance of the Australian dollar amid challenging financial markets before a recovery takes hold later this year.”  

MUFG expects monetary tightening to support the New Zealand dollar, even if economic data remains mixed, the RBNZ will be determined to raise rates further.

The Australian and New Zealand dollar forecasts have been revised down slightly. The Canadian dollar is also expected to receive support from a robust domestic economy and strong energy prices:

“While global growth forecasts are downgraded, growth will remain robust, with higher crude oil prices and strong export growth supporting Canada’s terms of trade. “Overall, MUFG expects the Canadian dollar to rise strongly over the course of the year, with the dollar to Canadian dollar (USD/CAD) exchange rate falling to 1.18 at the end of the year