FX markets learn to live with tariff uncertainty

The dollar's recent downtrend is expected to pause, with a 2-3% corrective bounce anticipated in Q3, driven by the diminishing impact of tariff news on FX and a renewed focus on macro factors. This rebound is predicated on expected US inflation from tariffs and a cautious Federal Reserve delaying rate cuts until December. However, this strength is seen as temporary, with the dollar's downtrend projected to resume by year-end once the Fed begins easing, while other G10 currencies like JPY and CHF face distinct domestic and hedging pressures.

Analysis

The US dollar's significant downtrend, which saw a 12% decline over the last six months, is showing signs of a temporary pause. The driver for this shift is a decreasing market sensitivity to tariff announcements, with a renewed focus on macroeconomic fundamentals. A key catalyst for a near-term dollar rebound is the anticipated pass-through of higher tariffs into US inflation data during the third quarter, a trend hinted at by business survey price components. This expected uptick in prices is likely to reinforce the Federal Reserve's cautious stance, delaying the start of an easing cycle until December. Consequently, a reversal of the June decline in short-term US rates is projected, potentially fueling a 2-3% corrective bounce for the dollar. In contrast, other G10 currencies face idiosyncratic pressures; the Japanese yen is vulnerable as rising government bond yields are being interpreted negatively amid fiscal policy uncertainty, potentially driving USD/JPY towards 150. Meanwhile, the Swiss franc's strength persists as the Swiss National Bank's intervention capacity is limited, solidifying its role as a hedge against deteriorating global conditions. This dollar strength is viewed as tactical, with the broader downtrend expected to resume by year-end following a projected 50bp Fed rate cut.

Key Decisions for Investors

• Consider a tactical long US dollar position for the third quarter to capitalize on the forecasted 2-3% corrective bounce driven by delayed Fed rate cuts.
• Monitor US inflation data closely, as higher-than-expected figures would validate the thesis for a hawkish Fed pause and support dollar strength.
• Evaluate a long USD/JPY trade, as the combination of firming US rates and perceived sovereign risk in Japan presents a potential catalyst for the pair to test the 150 level.
• For those seeking portfolio hedges, the Swiss franc remains a viable option due to the Swiss National Bank's limited ability to weaken the currency.
• Prepare to unwind bullish dollar positions towards year-end, as the structural downtrend is expected to resume once the Federal Reserve commences its easing cycle.