Forex markets: How far can the relief rally go?

Investing.com -- Donald Trump's inauguration week began with a relief rally in G10 currencies against the US dollar (USD), driven by a Wall Street Journal report hinting at a potential delay in tariffs.

UBS strategists, citing their short-term valuation model, analyzed the rally, assessing the extent of tariff risk priced into currencies as of the previous Friday, and consequently, the potential for the USD to weaken in the near term.

According to UBS, the most misaligned currencies at the start of the week were the Euro (EUR), Australian dollar (AUD), and New Zealand dollar (NZD), with fair values (FVs) estimated at approximately 1.0450, 0.6400, and 0.5750 respectively.

While UBS sees the EUR as likely to reach its near-term target, they are more skeptical about a significant rally in commodity currencies such as the AUD and NZD, citing persistent undervaluation and ongoing weakness in China.

The investment bank also maintains that, except for the Canadian dollar (CAD), long USD positions are not excessive enough to suggest a major correction for the EUR and Japanese yen (JPY).

“Ultimately, we think USD pullbacks represent buying opportunities,” strategists spearheaded by Vassili Serebriakov said in a note.

As the focus remains on the dollar, UBS notes that the yen is approaching significant event risk with the Bank of Japan (BoJ) meeting scheduled for January 24. Approximately 22 basis points of hikes are already expected, indicating that a 25 basis point increase may not lead to substantial JPY gains, even though it would reinforce the BoJ's divergence from the global policy easing trend.

UBS's equity hedge rebalancing model also indicates the possibility of JPY buying at the month's end.

Regarding the euro, strategists highlighted the currency’s resilience over the past two years, despite weak fundamentals. They attributed this strength to a strong Balance of Payments (BoP) surplus, driven by the return of foreign bond inflows.

However, UBS cautions that these inflows, especially into French debt, could be at risk if French political uncertainties persist and the European Central Bank (ECB) continues to lower rates.

“What we've seen so far is some weakening in demand for French debt, particularly from Japanese investors, but overall bond inflows remaining resilient through Nov,” strategists noted.

Looking ahead, they suggest keeping an eye on this sector as the attractiveness of the Eurozone yield environment for global investors may change.

Source: Investing.com