Investors are witnessing a cycle of depreciation of the dollar, justified from a fundamental point of view. It is set to continue, although its pace could slow down over the next few months. By Vasileios Gkionakis and Kiran Kowshik*

Currencies Since its cyclical peak at the end of March, the trade-weighted dollar index has fallen by around 10%. This is due to four factors:

1. The Federal Reserve is committed to keeping rates close to zero. Combined with the rise in inflation forecasts, this announcement led to a drop in US real rates;

2. Expectations of a recovery in activity and trade as economies reopen;

3. The major political shift in the euro zone in favor of budgetary cooperation and solidarity;

4. The worsening of the pandemic in the United States and the increased probability of a victory for Joe Biden in the presidential election in November.

This led to a dramatic rally in G10 currencies against the dollar: cycle-sensitive currencies outperformed and traditional reserve currencies appreciated. We expect a further decline in the US currency, which remains overvalued by around 8%, according to our estimates.

However, the pace of the dollar's decline is likely to slow somewhat over the next few months given the magnitude of the recent move. What consequences for the euro and the Swiss franc?

Regarding the euro/dollar, the exchange rate has soared in parallel with the decline of the dollar, even if the gains recorded by the single currency can also be explained by the political advances of the EU. Indeed, the historic turn taken in budgetary management in times of crisis has reduced the risk of redenomination and will continue to support the euro. While speculative long positions in EUR/USD have risen, they remain far from their previous stretched levels that led to trend reversals. At the same time, the EUR/USD is quite close to its equilibrium value (estimates of its fair value are between 1.18 and 1.25).

We expect a euro/dollar at 1.21 for the end of the year. At this stage, the risks are balanced. On the one hand, the EUR/USD regularly exceeds the level of its fair valuation; it is not excluded that this will happen again against a backdrop of political confusion in the United States and an upturn in Europe. On the other hand, a worsening of the pandemic or any other trade-destabilizing event would hurt the outlook for currencies in open economies.

On the Swiss franc side, the euro/Swiss franc pair failed to keep pace despite the appreciation of the euro/dollar. Indeed, most of the rise in EUR/USD can be explained by the depreciation of the dollar, as US real yields have fallen. It is therefore more difficult for Switzerland to recycle its current account surplus, which is also visible in the evolution of USD/CHF which fell to 0.90, its lowest level since the abandonment of the floor rate by the SNB in early 2015. As improving sentiment in the Eurozone boosts the next phase of EUR/USD recovery, EUR/CHF is expected to recover slightly while showing less correlation to EUR/USD . We expect an exchange rate of 1.11 for EUR/CHF by the end of the year.

Regarding risks, a second wave of Covid-19 affecting Europe would increase the demand for francs. The Swiss currency could also be favored by a resurgence of the Sino-American trade war.

*Vasileios Gkionakis and Kiran Kowshik, bank Lombard Odier & Cie