Yield Differentials to Dominate Currency Markets, Deutsche Bank Says

Interest rate differentials have become the dominant force in foreign exchange markets this year, with carry trade strategies expected to continue performing well in a stable global economy, according to a Deutsche Bank AG note published Friday.

George Saravelos, the bank's head of currency strategy, wrote that risk-adjusted carry has been the most significant factor behind currency movements in 2026. This trend has persisted despite major events such as a war in the Middle East, leadership changes at the Federal Reserve, and significant valuation shifts in technology stocks.

Outlook for Major Currencies

Deutsche Bank provided an outlook on several key currencies, emphasizing the role of central bank policy and yield expectations.

• U.S. Dollar (USD): The hawkish repricing of Federal Reserve policy has been the most important positive driver for the dollar, Saravelos noted. However, for the dollar to experience a broad rally and regain its status as a high-yielder, the market would need to price in rate hikes of 75 to 100 basis points or more.
• Euro (EUR): The bank does not see a compelling reason for the euro to fall further, citing potential upside risks to European growth expectations that could support the common currency.

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Yen and Franc as Funding Currencies

The Japanese yen (JPY) continues to face pressure from its low front-end yields compared to other major currencies, making it a popular choice for funding carry trades. However, Deutsche Bank's analysts noted they prefer using the Swiss franc (CHF) for this purpose.

Despite the current weakness, the yen could find strength from domestic policy shifts. Saravelos pointed to Japan's efforts to promote domestic investment, recalling the 2014 Government Pension Investment Fund reform as an example of how changes in domestic flow expectations can trigger significant currency movements, even if policy implementation takes time.