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The dollar could emerge as the “cleanest dirty shirt” yet again.

The dollar’s decline from its September highs could continue for several months yet, with depressed volatility supporting outward capital flows and limiting the currency’s safe-haven appeal. But the key conditions for a decisive move lower – a clear peak in US interest rates and a period of economic underperformance relative to the rest of the world – have yet to play out, and in the longer term, we think the risk outlook for other major trading blocs looks asymmetric, with structural vulnerabilities often outweighing the potential for sustained gains.

The euro is, perhaps, the currency best positioned for outpeformance against the dollar in the second half. It is deeply undervalued on most metrics, and typically exhibits greater resilience in the early stages of a global downturn. But bank lending volumes are worsening across the bloc, higher borrowing costs are damaging consumer confidence, and the European Central Bank looks likely to tighten into a slowdown.The UK is facing stagflationary risks, with persistent inflation and ever-tighter financial conditions threatening to push the economy into recession. Recent price action would suggest growth fears are beginning to trump policy rate increases in influencing the pound’s direction.

In China, where an early-year rebound is fading, the central bank and other parts of the policy apparatus seem poised to ramp up stimulus efforts after the July politburo. Targeted fiscal spending, relaxation of property sector restrictions, and monetary loosening are all on the menu, with rate differentials unlikely to tilt dramatically in the renminbi’s favour.

Even if adjusted, the Bank of Japan’s yield-suppression efforts should leave the yen with an important role in funding global carry trades – and half-hearted intervention efforts aren’t likely to decisively pull the currency out of its slump.

Although evidence of weakness has been slow to appear, we worry that both Australia and Canada could suffer outsized declines in household consumption – along with currency weakness – as borrowing costs build over time.

Taken in sum, this adds up to a scenario in which the greenback weakens through the early part of the third quarter, but slows its decline toward the end of the year – and one in which another round of financial turbulence could easily topple current market assumptions, with low-carry and growth-sensitive currencies in the line of fire if a classic flight-to-safety response unfolds.

Nominal forecast currency returns by quarter, relative to current levels, %

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