Is the exchange rate relative to interest rates underestimated, and has the weak US dollar "reached the end"?

After the July non-farm unemployment rate triggered a recession warning, recession trades and rate cut trades continued to alternate, and the US dollar has shown weakness in recent months. The market mostly believes that as the Fed begins a rate-cutting cycle in September, the dollar may continue to be weak. However, HSBC believes that the current exchange rate relative to the US interest rate market is underestimated, indicating that the dollar may be on the verge of a rebound.

In a recent research report released, analysts at HSBC such as Daragh Maher pointed out that concerns about a US economic recession may be exaggerated. The analysts wrote:

The US economy may slow down, which is expected as the (Fed) has already implemented a monetary tightening policy, but we believe that the recession panic triggered by the July (non-farm) employment report has clearly been exaggerated (and is temporary).

Recent data on retail consumption and other indicators suggest that the US economy is still likely to achieve a soft landing. The market believes that this will prompt the Fed to cut rates at every meeting for the rest of the year, with one cut possibly being 50 basis points, totaling 100 basis points for the year. However, HSBC points out:

Unless the economy actually deteriorates catastrophically, the Fed's actual actions may not be looser than what the market currently expects.

Considering that the market's dovish expectations for Fed policy are already very aggressive, HSBC emphasizes that the weakness of the dollar may have reached its limit. If the Fed's confidence in a soft landing strengthens, the dollar may be supported by a cooling of rate cut expectations. The institution stated:

First, even if we accept the market's suggestion that the Fed may cut rates by 100 basis points before the end of the year, the dollar looks too weak relative to these dovish rate expectations.

Second, we do not believe that the US macro story will prove this loose pace to be reasonable, considering the lack of evidence of an imminent recession, we believe that a 50 basis point rate cut is unnecessary for a "soft landing" scenario.

Combining these two factors, along with the fact that the US dollar index has returned to its low point in December 2023, gives us reasons to be bullish on the dollar.

Euro, Yen Under Pressure

Due to market aversion to the dollar, the euro has recently shown strength, with the euro to dollar exchange rate breaking the high point of December 2023.

HSBC believes that although the European Central Bank's attitude tends to be hawkish, this support for the euro is limited, and if the dollar regains market favor, the euro may face pressure again.

HSBC expects the euro to dollar exchange rate to fluctuate in the range of 1.1000-1.1276 in the coming weeks. As of the time of writing, the euro to dollar exchange rate is 1.1069

Regarding the Japanese Yen, HSBC pointed out that although the USD/JPY exchange rate has fallen from previous highs, this adjustment may have already ended. With the market repricing the Fed's policy path, the US dollar is making a strong comeback, posing a risk of a pullback for the Japanese Yen.

HSBC also proposed a trading idea, which is to buy USD/CHF at 0.8490, with a target price of 0.8740 and a stop-loss price of 0.8390.

We have decided to take advantage of our expectations for a USD rebound to operate on the undervalued USD/CHF exchange rate. We believe that the Swiss Franc has recently risen too high and too far, its strength has exceeded the changes in interest differentials, and it is inconsistent with the previous unwinding of interest rate trades.

Due to Swiss inflation being lower than the Swiss National Bank's forecast, policymakers may also have limited tolerance for the strength of the Swiss Franc. As two safe-haven currencies, USD/CHF also eliminates some of the uncertainty in risk preferences regarding how the market may react to the Fed being less dovish