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Three major G3 central banks (CBs) will likely signal three directions this week. Although broad global cues are similar – of waning growth and inflation momentum – varying domestic backdrops and imperatives will push the Fed, ECB and BoJ to sound different from one another. FX markets, in particular, are already taking cues from these diverging paths of CBs. Although we respect the price action, the remainder of the global picture falls short of conditions historically associated with sustained USD weakness.

Dovish Fed hike? While the outcome of Wednesday’s FOMC is straightforward (25bps unanimous hike), we suspect the forward guidance will still indicate that the June dot plot is still relevant (implying one more hike post-July), while caveating that future policy decisions are not predetermined, and any additional tightening will be data-dependent. While June CPI was certainly welcome, it will probably take a few more favorable outcomes to influence the FOMC’s thinking more meaningfully. While labor markets remain tight enough, we maintain that the economic lags of massive hikes will not necessarily require further hikes beyond July.

ECB’s neutral state? The ECB is in no position to be dovish – in fact, it has been flagging an upcoming rate hike, backed by an upward revision in inflation forecasts. However, growth momentum is waning rapidly, and headline inflation is now trending lower. We expect the ECB’s tone to be neutral, directing towards another hike in September. However, we see enough slowdown in growth and core inflation for it to pause in the next quarter. Large downside surprises would raise questions about a September hike, while upside surprises would clearly strengthen the hiking bias. However, in both cases, we expect the ECB to stay non-committal.

Tricky BoJ? Pinning down the timing of a shift in BoJ policy remains difficult, and policymakers have stated that moves will not be signaled in advance. With firming underlying inflation and the likelihood of BoJ raising its inflation forecast for 2023/2024 significantly, its earlier argument that "the rise in inflation is temporary" becomes a bit untenable. In light of this, we think an appropriate response would be to widen the 10Y YCC trading band to +/-1% this week from +/-0.5%. That said, several media reports are suggesting the BoJ does not see an immediate need to adjust the policy. We think it will be a tricky strategy to keep the policy unchanged while adjusting forecasts to show inflation above the target for two consecutive years. In addition to posing a possible credibility problem and adding downward pressure on Yen, it raises the likelihood of a more abrupt policy adjustment and increased market volatility ahead.

FX view: Dollar breakdown to face resistance? FX markets are already taking cues from these divergent monetary policy paths. After oscillating in a range for most of the year, the DXY collapsed in one of its largest weekly losses of the last decade (down 2.3% in mid-July). Essentially, the market tone is that there is now a wider runway for a soft landing and Fed’s terminal state (US’ Goldilocks scenario). We respect the price action, but it remains the case that the rest of the global picture falls short of conditions more historically associated with sustained USD weakness. For us, the core of the USD-bullish view has been global in nature, following China’s downdraft and the subsequent weakness in Europe in Q2.

The recent USD correction has been helped by the sharp repricing of US forward rates curves implying material easing through 2024, with more cuts priced in than all other peers. However, an already discounted state of the US suggests the bar for further US-yield-led USD weakness is rising, especially considering that the Fed would still not be cutting rates this year. This may instead require a significant shock repricing of higher yields outside the US, which would also imply a complete breakdown in global inflation correlations or a stagflationary state in the rest of the world.

Key highlights:

* Fed, ECB to hike 25bps

* BoJ stance remains uncertain

* Dollar breakdown likely to be temporary

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