October’s meeting of finance ministers and central bankers in Washington took place in similar circumstances to the 1985 Plaza Accord. Japan, West Germany, France and the UK – at the time the world’s largest economies after the US and the Soviet Union – had seen their currencies depreciate by around 50% against the dollar during the first half of the 1980s on the back of high US interest rates and a strong economy.
In the weeks leading up to the G20 gathering in 2022, sterling had hit its lowest level against the dollar since the mid-1980s and the yen had not been as weak since the late 1990s.
The Fed is nearing the end of its rate hike cycle and while global growth is slowing, it could bottom in the coming months
Paul Mackel, HSBC
Any optimism that the October get-together of monetary policy-setters would result in the US sticking a pin in the dollar bubble was short-lived. But the events of the past few months offer the prospect of the world’s dominant reserve currency continuing its recent correction.
According to Paul Mackel, global head of FX research at HSBC, there are good reasons to believe that the big picture trend for the USD has changed for the worse. “The Fed is nearing the end of its rate hike cycle and while global growth is slowing, it could bottom in the coming months,” he says.
BNP Paribas Markets 360 believes the USD is entering a multi-year bearish trend, noting that it appears quite rich – about 25% – relative to its long-term fair value.
“We also expect a structural shift in flows that would be less supportive, whereby eurozone and Japanese investors repatriate cash with yields turning positive at home, or increase hedge ratios on their existing and sizeable holdings of US fixed income,” says FX strategist Parisha Saimbi.
Deutsche Bank sees the dollar having reached a medium-term peak and now entering a sustained downtrend. As global negative supply (European energy) and demand (China) reverse, and the end to the Fed hiking cycle comes into view, investor dollar cash balances should start coming down and the US risk premium start to recede.
We also expect a structural shift in flows that would be less supportive
Parisha Saimbi, BNP Paribas Markets 360
“Moreover, relative growth dynamics should favour the rest of the world over the US during 2023, not only helped by Chinese re-opening but also by sustained downside risk to the US fiscal stance – most notably the debt ceiling,” says Shreyas Gopal, strategist at Deutsche Bank.
However, John Velis, FX and macro strategist at BNY Mellon, refers to “mild depreciation” from the heights of 2022. The broad trade-weighted dollar index is down nearly 8% since the end of October – and 2% since the beginning of 2023 – so a lot of the expected depreciation has already happened.
There is also some unease about whether the market pricing of rate cuts could prove to be wrong – which would not be a new phenomenon, as the Fed had to reinforce its view repeatedly that the inflation battle is a challenging one and it is in no rush to lower rates.
Velis notes that there is a split between what the Fed has been saying and what the market expects for monetary policy as the world moves deeper into 2023, with various Fed officials having said that they do not expect rate cuts this year once the central bank has stopped hiking to a level of around 5%.
Pricing in the market indicates an expectation of rate cuts as early as autumn and although the market agrees that the terminal rate in this cycle will be 5%, it sees rates back below 4.5% by year-end.
“Although the softer US inflation pattern lately goes against the Fed’s thinking, this does not mean rate cuts are forthcoming and hence a stronger hawkish message from the Fed could re-energize the USD temporarily,” says HSBC’s Mackel.
Our quantitative indicators suggest FX investors have built up short USD exposure now and that it is less attractive to be adding risk here
Alexander Jekov, BNP Paribas Markets 360
As expected, the Federal Open Market Committee raised its key interest rate this week by 25 basis points, a further step down from increases of 75bp increase in November and 50bp in December. But it was rather coy about where it might go from here, with a reference to inflation remaining elevated followed by the suggestion that ongoing increases in the target range would be appropriate to return inflation to its target of 2%.
There is uncertainty over whether the US hiking cycle is more likely to end as soon as March or later in the year. Further degrees of uncertainty come around whether the Fed will then proceed to cut rates later in the year, and if so at what speed.
“While uncertainty is high, our view is that core inflation will be lower by the end of the year than the Fed currently fears, but that the risks are that unemployment is higher, which in turn would open the door to monetary policy easing before the year is done,” says Gopal at Deutsche.
The path lower could be bumpy, especially if earnings downgrades weigh on risk assets – a key driver of FX markets currently – or the Fed more explicitly pushes back on the markets’ pricing of rate cuts this year, or some other risk-off shock occurs.
The inherent appeal of the dollar also means that it could still end up tracking higher during the coming months, for example if a weakening of the global economy led to renewed interest in its safe-haven properties – and geopolitical risks and the potential for rising cross-asset volatility cannot be ignored either.
“Our quantitative indicators suggest FX investors have built up short USD exposure now and that it is less attractive to be adding risk here,” adds BNP Paribas Markets 360 FX strategist Alexander Jekov.
Gopal agrees that the biggest risk to the negative dollar view is a systemic financial event accompanied by large risk aversion that creates renewed demand for the USD as a safe haven, similar to the onset of the pandemic in March 2020.
“And if concerns about the looming debt-ceiling procedure begin to build, the dollar could – ironically – be sought out as a safe-haven asset,” adds Velis at BNY Mellon.
