Further dollar weakness not a given, EURUSD overshooting fundamentals: UBS

Investing.com -- The US dollar has weakened this week as equity markets rebounded from early-August declines, while expectations for a more dovish Federal Reserve have persisted.

UBS Global Research analysts caution against assuming a sustained downturn in the US dollar. Although the euro has reached a new high against the US dollar in 2024, the rally may be overextended relative to economic fundamentals.

EURUSD has risen sharply, driven by improved risk sentiment and a partial recovery in equity markets, with the S&P 500 regaining its August losses and volatility indices like the VIX falling.

Despite this rally, US front-end yields have only modestly rebounded, and market pricing suggests nearly 100 basis points (bp) of Fed rate cuts this year, including a possible 50bp reduction in September.

This market positioning indicates that further significant dollar weakness may face high hurdles, especially with expectations for Fed policy already largely priced in.

“Recent price action raises the question of whether the market is finally shifting to a broad-based bearish USD view and whether the dollar is on a cusp of significant further weakness,” said analysts from UBS Global Research.

Although the Fed appears poised to ease policy, likely with a 25bp cut in September, the market's aggressive expectations may leave little room for dovish surprises. Any positive US economic data, such as a rebound in non-farm payrolls (NFP), could lead to a tactical recovery in yields and the USD.

Analysts also flag that the broader global economic outlook remains uncertain, with limited signs of improvement outside the US. China's stimulus efforts have yet to convince markets, and the Eurozone continues to face downward revisions in growth forecasts. These factors reduce the likelihood of a significant shift away from the dollar and US assets.

EURUSD's recent climb, surpassing previous highs, is viewed by UBS analysts as an overshoot relative to short-term fundamentals. The brokerage’s model estimates fair value for EURUSD closer to 1.0950, below the current levels.

The deviation suggests that the pair is pricing in either unanticipated US weakness or excessive optimism about Europe’s economic prospects. However, UBS remains skeptical about the Eurozone's growth outlook, pointing to negative economic surprises and ongoing headwinds in major economies like Germany.

Given these considerations, the analysts believe that EURUSD may struggle to maintain levels above 1.11 for an extended period, especially if upcoming Eurozone data fails to meet expectations.

UBS analysts also discuss other major currencies, noting that recent movements in the Japanese yen and Swiss franc are more reflective of global risk sentiment rather than fundamental shifts.

Morgan Stanley (NYSE:MS) expects the Bank of Japan to maintain a cautious approach, which could lead to a USDJPY rebound, offering a better entry point for shorts. Meanwhile, they see limited downside for the Swiss franc and expect EURCHF to remain range-bound near current levels.

In the Scandinavian region, UBS analysts favor the Norwegian krone over the Swedish krona, citing a more constructive central bank outlook in Norway. They recommend maintaining a short position in EURNOK, predicting that NOK’s recent bounce is more sustainable compared to SEK’s recovery.

This article first appeared in Investing.com