In our Mid-Year International Economic Outlook, we highlighted that the economic divergence that was apparent during the early part of 2024 now appeared to be turning to economic convergence. Specifically, economies that performed well during the early part of this year, such as the United States and China, have begun to show a loss of momentum, while other regions that finished 2023 on a challenging note, including most notably the Eurozone and United Kingdom, have increasingly shown signs of recovery. This transition from divergence to convergence has continued over the past month, albeit primarily through a further waning in U.S. economic outperformance. While the deceleration in U.S. growth so far remains smooth, there are signs the growth slowdown is becoming more widespread. June nonfarm payrolls rose by a respectable 206,000, but prior months' jobs gains were revised lower and the unemployment rate ticked higher. Other timely indicators such as the ISM manufacturing and services indices printed at 48.5 and 48.8, respectively. While the drop in the June ISM services was unusually large, the underlying trend in service sector activity still appears to be clearly slower over time (Figure 1). Finally, as growth in real household incomes has slowed, growth in consumer spending also appears to be moderating. Overall, our base case remains for an ongoing slowdown in the U.S. economy over the medium term. After GDP growth of 2.5% in 2023, we forecast U.S. economic growth of 2.3% in 2024 and 1.9% in 2025.

The United States is not the only major economy that appears to be slowing after a solid start to this year. China's Q2 GDP rose 0.7% quarter-over-quarter, less than half the Q1 increase and below the consensus forecast for a 0.9% gain. GDP growth also slowed to 4.7% year-over-year (Figure 2). Weak domestic consumption seems to be the primary driver of China's softening economic momentum. In Q2, consumption contributed only 2.2 percentage points of the economy's overall year-on-year growth, meaningfully lower than the contribution experienced in Q1. China's economy seemingly lost momentum as the second quarter progressed, also led by decelerating consumer activity. June retail sales rose just 2.0% and services production eased to 4.7% as persistent subdued inflation/disinflation pressures, a real estate sector that remains in correction, and household preferences to save all contribute to a local backdrop that is not conducive to spending. China's recent economic slowdown may be driven by soft consumption, although pockets of weakness exist outside of consumption. China's manufacturing sector remains in contraction territory, and exports positively contributed to Q2 GDP, we believe China becoming a less integral part of the global supply chain can challenge China's export-led economic model over the medium to longer term. After GDP growth of 5.2% in 2023, and incorporating Q2 data into our forecast profile, we have now lowered our GDP growth forecast for 2024 to 4.8% and see a further growth deceleration in 2025 to 4.5%.

While a gradual growth descent for the U.S. is continuing and China is decelerating again, recent figures for other key international economies remain consistent with an overall upswing. In particular, our view remains for economic growth in the Eurozone and United Kingdom to strengthen gradually over time. To be sure, recent economic news has been mixed. In the Eurozone, the manufacturing and service sector PMIs both fell in June, though concerns surrounding the recent French elections was likely a contributing factor. Worries about the right-wing National Rally or left-wing New Popular Front have spurred concerns about a wider French government budget deficit and increased bond yields, contributing to increased uncertainty. However, the worst-case election fears were avoided, with no single coalition of political parties securing an outright majority. While negotiations over the makeup of a new French government could continue for many weeks or even months, we do expect uncertainty to ease and sentiment to improve over time. Against that backdrop, we think the case for a European economic recovery remains intact, with the strengthening trend in Eurozone real household incomes likely to be increasingly supportive of consumer spending (Figure 3). In addition to firming Eurozone growth prospects, lingering inflation concerns persist, as Q1 compensation per employee edged up to 5.1% year-over-year, and services inflation remained elevated at 4.1% in June. Against this backdrop the European Central Bank held its Deposit Rate at 3.75% at its July meeting and said it remains data dependent, showing little inclination to fully commit to a September rate cut ahead of time. Considering recent growth and inflation figures, our outlook has shifted toward a more gradual pace of ECB monetary easing in recent months. We anticipate two more rate cuts this year, in September and December, and a further cumulative 100 bps of rate reductions in 2025. If wage and price pressures remain sticky, however, we would not be surprised by later or even more gradual ECB easing.

The United Kingdom similarly appears to still be on an overall economic upswing. Sentiment surveys have again been mixed as the U.K. manufacturing PMI has generally increased in recent months, while the services PMI has declined. However, monthly GDP figures, including a 0.4% month-over-month gain in May, point to solid economic momentum during Q2 while, as in the Eurozone, strengthening growth in real household incomes should prove supportive of consumer spending over time. The U.K. general election, which saw a landslide victory for the Labour party, passed smoothly and without incident. Considering these developments, we have raised our U.K. GDP growth forecasts slightly to 1.0% for 2024 and 1.5% for 2025. Meanwhile, U.K. services inflation remained elevated at 5.7% year-over-year in June (Figure 4) and wage growth is easing only slowly. Accordingly, while we expect an initial Bank of England rate cut in August and only a gradual pace of easing over time, we would not be surprised if central bank rate cuts were delayed even further, possibly to the Bank of England's September meeting.

The news from Japan has also been mixed as Q1 GDP was revised to show a larger than previously reported decline, but looking ahead, the details of the Q2 Tankan survey were more encouraging for growth prospects. Also of note, May labor earnings data indicated that the historically large increases agreed to at this year's spring wage talks are starting to be reflected in monthly paychecks, providing increased support for the view that a virtuous cycle between wages, incomes and prices could intensify. Considering improvement in some Japanese economic indicators, even if that improvement is uneven, along with some desire from Bank of Japan (BoJ) policymakers to at least partly normalize its monetary policy stance, we expect further tightening in the months and quarters ahead. In late July, the BoJ is scheduled to announce a detailed plan on how it will go about reducing the pace of its bond purchases over the next several quarters. We also forecast a 15 bps rate hike from the BoJ in October, followed by a 25 bps rate hike from the BoJ in April 2025. Japanese authorities have also shown some sensitivity to excess weakness in the yen in recent months, with intervention to support the Japanese currency seen in late April and early May, and likely again during July. Together, the likelihood of further Japanese monetary policy normalization, along with the potential for further FX intervention, could offer some support to the yen over the medium term, especially once the Fed begins to lower U.S. policy interest rates in earnest.

The outlook for relatively gradual monetary easing (or indeed gradual monetary policy tightening) is not confined to the Eurozone, United Kingdom and Japan (Figure 5). Elevated inflation in Australia, New Zealand and Norway has also seen us adopt a forecast for a more gradual pace of easing from those respective central banks in recent months. We do not expect the Reserve Bank of Australia to begin lowering interest rates until early 2025. We also expect policy interest rates for the Reserve Bank of New Zealand and Norges Bank to stay elevated for an extended period. That said, a less hawkish monetary policy announcement from New Zealand recently and a downside inflation surprise from Norway means there is still potential for those central banks to begin easing monetary policy before the end of this year. There are of course often exceptions to the general rule, and in this case those exceptions appear to be Canada and Sweden. For Canada, a softening labor market, subdued business confidence and inflation trends that remain benign and well-behaved overall mean we now expect back-to-back rate cuts, and see the Bank of Canada cutting interest rates in July after it initiated its easing cycle at its June announcement. In Sweden, relatively soft economic growth, downside inflation surprises and an overall dovish central bank mean we still forecast three more 25 bps rate cuts before the end of this year.

We have made only moderate changes to our forecast for the U.S. dollar this month. For now, our outlook remains for some residual U.S. dollar strength through late 2024. While U.S. policy interest rates remain elevated, and with potential uncertainty surrounding the U.S presidential election, we expect the greenback can remain supported for the time being. One currency that could face further downside and underperform is the Canadian dollar. A further slowdown in Canadian economic growth and a relatively steady pace of rate cuts from the Bank of Canada could see the Canadian currency underperform versus the greenback and G10 currency peers during the balance of 2024. Over time, however, and as the overall swing from economic divergence to economic convergence continues to play out, we continue to see potential for moderate U.S. dollar weakness over the medium term (Figure 6). In our view, the combination of the Fed cutting interest rates and slower U.S. economic growth could place depreciation pressure on the U.S. dollar for an extended period of time. The trend toward economic deceleration in the United States is becoming increasingly visible, as evidenced by an economic surprise index that recently reached its lowest level since 2015 (Figure 7). That is in contrast to some key foreign advanced economies that continue to show overall improvement. Moreover, unlike some foreign central banks that in recent months have hinted at more gradual easing based on lingering inflation concerns, the Fed appears to be steadily proceeding toward an initial September rate cut. Essentially, we would argue that should the U.S economy remain on its current (slowing) path, U.S. economic performance and U.S. policy interest rates should continue to converge closer to those of other major economies, which should result in modest U.S. dollar depreciation through 2025. In addition, we note that global financial conditions have eased over the past several months as inflation pressures have lessened, and monetary easing has become more widespread. This is also reflected is equity market indices such as the U.S. S&P 500 and MSCI World Equity Index, which have reached record highs during 2024 (Figure 8). As long as global financial conditions remain generally benign and global equity sentiment generally upbeat, demand for safe-haven currencies such as the U.S. dollar could also be somewhat limited over time. In that environment, sentiment toward foreign currencies—particularly the more risk-sensitive currencies—could improve. These dynamics could support foreign currencies, both in the G10 and emerging markets, over the medium term.

Over the longer term and through much of 2025, we view the Japanese yen as well-placed to benefit from Fed easing and lower U.S. bond yields. A narrowing of yield differentials between the U.S. and Japan has not offered significant support to the yen just yet; however, we expect that as yield differentials continue to narrow, interest rates will prove to be more supportive for the yen versus the U.S. dollar. We also expect the Australian dollar to outperform over the medium term. Given still-elevated wage growth and inflation and a hawkish-leaning Reserve Bank of Australia, we do not expect an initial rate cut until February 2025, well after the Federal Reserve. We also forecast only a gradual pace of Australian central bank rate cuts thereafter. Outperformers can also be found in the emerging markets. Thematically, we believe currencies associated with relatively attractive carry and limited political risk can especially perform well over the medium term. In that sense, as we have stated in prior publications, we still believe the Mexican peso can be a notable outperformer going forward. We are not convinced Mexico's new administration, or even the current administration under AMLO, will pursue widespread constitutional amendments that significantly alter Mexico's democratic, legal and judiciary landscape. In short, Mexico has too much to lose by adjusting the constitution, and we believe cooler heads will ultimately prevail. Banxico is also somewhat cautious on resuming rate cuts, which can still offer an attractive carry for the peso. While the peso has moved in line with our theory over the past month or so, we believe a further Mexican peso recovery can still materialize going forward.

While we forecast modest U.S. dollar depreciation over time, the chance of a scenario that incorporates a more extended period of U.S. dollar strength is gaining increased prominence. Recent events—including the assassination attempt on former President Trump as well as President Biden not seeking re-election—combined with political opinion polling have drawn attention to the possibility of a Republican-led U.S. administration. In a scenario where the Republicans do sweep the presidency, Senate and House, we see more chance of important policy shifts that could be supportive of the greenback. First and most important, fiscal policy could potentially be more expansive under a Republican-led administration. The Tax Cuts and Jobs Act (TCJA), which was enacted in 2017, is set to expire at the end of 2025. While the reduced taxes for corporations from that act were permanent, many of the tax changes for individuals and smaller business are scheduled to end. The Congressional Budget Office has estimated that fully extending the expiring provisions would cost US$3.5 trillion over the next decade, amounting to deficits that are 1.0%-1.5% of GDP larger per year. Even though the federal budget deficit is already wide at around 6% of GDP (Figure 9), we view the chance of an extension, and perhaps even an expansion, of the existing tax reductions as more likely under a Republican-led administration, especially taking into account that the TJCA was initially passed during Trump's 2016-2020 presidential term. All else equal, fiscal stimulus in isolation should be associated with firmer U.S. economic growth, higher inflation and thus potentially less Fed easing and higher bond yields. More expansive fiscal policy could negate a portion of the U.S. economic slowdown we currently anticipate and, also accompanied by higher interest rates, provide a more extended period of support for U.S. dollar strength.

Another Republican-led policy shift with potential stronger dollar implications would be the imposition of new tariffs (Figure 10). To be sure, President Biden recently announced increased tariffs on Chinese products, including steel, aluminum, semiconductors, electric vehicles, batteries, solar cells, ship-to-shore cranes and some medical products. That said, Chinese imports affected by Biden tariffs amount to only US$18 billion, and thus the broader impact on the U.S. economy and financial markets is likely to be inconsequential. Republican presidential nominee Trump has suggested he could raise the tariff rate on all Chinese imports to 60%, as well as enacting an across-the-board 10% tariff on all imports from other countries. Even though imports of goods account for only around 11% of U.S. GDP, and imports of goods and services combined only around 14% of GDP, the widespread imposition of tariffs would nonetheless likely prove moderately inflationary. Tariffs, as well as any retaliatory tariffs, would likely be a drag on growth. While higher tariffs could divert some U.S. demand from imports to domestic production and improve U.S. external balances, the most significant impact on growth would likely be from higher inflation and reduced real household incomes and spending. Drawing on our U.S. economists' recent work again, a mix of higher inflation and lower growth could ultimately in fact result in higher unemployment, and in turn, lower U.S. policy rates. The extent of monetary easing, however, would depend on the hit to economic activity, but on balance, rate cuts could intensify in an environment of higher tariffs.

However, despite more aggressive Fed easing than we expect, higher tariffs could still result in greenback strength. We say that as the uncertainty associated with more protectionist U.S. trade policy could result in increased demand for safe-haven assets, including the U.S. dollar. An environment of higher inflation and lower growth could prove challenging for corporate earnings and equity markets. Historically, in times of policy uncertainty and volatile equity markets, despite the shock originating from the U.S., the U.S. dollar tends to broadly strengthen. So, while interest rates may fall more rapidly in the U.S. in an environment of higher tariffs, safe-haven demand could ultimately be the driving force of the dollar and be supportive of the greenback. For now, this scenario remains a hypothetical, and as we have seen in recent weeks, political dynamics can change rapidly. Scenario analysis is critical at this stage of the U.S. election cycle, and while we note that risks to the longer-term direction of the U.S. dollar are tilted to the upside, we have not incorporated any U.S. election outcomes or policy mixes into our currency forecasts. Should the Republican-led scenario ultimately materialize, and depending on the policy mix that gets implemented, our long-term dollar views could change to reflect either less greenback weakness or outright dollar strength.