Yesterday's surprise rate hike by the Bank of Canada (BoC) triggered quite a clean reaction in FX markets. Of course, the Canadian dollar rallied on the view that the BoC had unfinished business when it came to tightening. But the broader reaction was for short-dated yields to rise around the world, for yield curves to invert further, and for the dollar to strengthen.

USD/JPY rose about 0.8% after the BoC hiked. The view here was that if both Australia and Canada felt the need for further hikes, in all probability the Fed would too. 

This endurance of this late cycle dollar strength is therefore the key story for this summer. For the near term, it looks like the dollar can hold the majority of its recent gains into next Wednesday's FOMC meeting - though the release of the US May CPI next Tuesday will be a big market driver too.

ING's bigger picture call remains that the dollar will embark on a cyclical bear trend in 2H23 - probably starting in 3Q - though the risk is that this gets delayed. 

This brings us to our second key observation which is that declining levels of cross-market volatility continue to favour the FX carry trade. Somewhat amazingly the VIX index - implied volatility for the S&P 500 equity index - has fallen below not just the 22 February pre-invasion levels but also below the March 2020 pre-pandemic levels. As is the case with low rates and FX volatility, presumably investors believe that policy rates will not be moving too much this year - perhaps a little higher and then a little lower.

Lower volatility levels are favouring the carry trade which in the EM world favours the Mexican peso and the Hungarian forint and in the G10 space favours the Canadian dollar. An investor selling USD/MXN six months forward at the start of the year would have made close to 16% by now.

Expect these core trends to continue for the near term. The data calendar is light today and we suspect a slight pick-up in initial claims will not be enough to move the needle on the dollar. Expect DXY to linger around 104.