Divergence Is Here to Stay

Equity markets have surged since a fragile ceasefire was announced last week. History suggests markets don’t wait for clarity, only for peak risk to pass. But monetary policy is more nuanced. Central banks are left with an awkward trade-off between “stag” and “flation.” Currency trends have also become harder to call. Does the end of flight to quality put US dollar weakness back in play?

The IMF–World Bank meetings usually help align policymakers and investors around a shared economic and policy narrative. The meetings in Washington, DC, this week yielded a broad consensus around three points. First, the global economy has absorbed successive shocks better than many feared. Labour markets in advanced economies remain relatively tight, financial systems are functioning and trade has held up. Second, public debt levels are now significantly higher than before the pandemic, leaving far less fiscal room to respond to future shocks. And third, geopolitical conflict is no longer a tail risk—it’s the baseline.

But when it comes to monetary policy, central bankers are splitting into two camps. One camp has argued for patience: inflation expectations remain anchored, and monetary policy was well calibrated before the shock. This group includes the Bank of Canada, the Bank of Mexico and probably the Federal Reserve. The other camp argues for credibility: they argue that central banks must be prepared to act early, even if growth slows, to prevent second-round inflation. This view appears widely shared among European central bankers, the Reserve Bank of Australia and the Monetary Authority of Singapore. A quick look at the OIS markets confirms this duality (graph 1).

Currency traders have kept calm and carried on. The US dollar benefited disproportionately from a flight to quality in March but gave back these gains once risk appetite improved. Intra-day correlations between risk sentiment and the US dollar have been unusually strong since the Iran conflict began. But take a step back, and it’s clear that the broad US dollar has basically been in a range over the last 12 months (graph 2). The closely followed DXY index has been stuck between 101 and 96. USDCAD has been fluctuating in a narrow 1.35–1.41 band. These ranges have survived powerful narratives like “de-dollarization,” assault on the Fed’s independence and shifting views on the safe haven appeal of the greenback. We believe the US dollar is in a long-term decline. But currencies are a beauty contest, and the other major currencies come with blemishes of their own.

Policy divergence is a powerful catalyst for currency markets. As such, we are carefully monitoring rate differentials as a potential catalyst for USD weakness in the coming months. The OIS market now expects the Fed to remain on hold this year but cut rates eventually next year. On the other hand, some analysts are predicting the ECB will hike in June. If interest rate spreads clearly shift against the US dollar, the year-long trading ranges could finally break down.