Synopsis: Bank of America (BofA) discusses the potential shift from the US dollar's (USD) carry advantage to a significant headwind as global central banks, excluding Japan, transition from hiking to cutting rates. Despite recent market reassessments, the Federal Reserve (Fed) is anticipated to be among the first G10 central banks to initiate rate cuts. This shift is expected to impact the USD negatively due to several factors including the scope for US rates to fall further compared to other regions, the USD's current overvaluation, and the influence of lower US rates on global risk sentiment.
Here are the 4 reasons highlighted by BofA for this eventual flip from carry advantage to a headwind for the USD:
1- Early Fed Cuts: The Fed is predicted to be one of the initial G10 central banks to reduce rates, challenging the USD's carry advantage.
2- Rate Differential Compression: Given the higher starting point of US rates, their potential reduction could significantly narrow the rate differentials with other currencies, diminishing the USD's attractiveness.
3- USD Overvaluation: The USD stands as one of the most overvalued currencies in the G10, a factor that could amplify its vulnerability in a rate-cutting environment.
4- Impact on Global Risk Appetite: Lower interest rates in the US typically boost global risk appetite, a dynamic that historically benefits currencies other than the USD.
Conclusion: BofA outlines a future scenario where the USD's current carry advantage transitions into a headwind due to anticipated early rate cuts by the Fed, greater room for rate reductions in the US, and the USD's overvaluation. These factors, combined with the effect of lower US rates on global risk appetite, suggest a challenging period ahead for the USD as global central banks shift their policy stance.