November 30, 2022
Scott Wren, Senior Global Market Strategist
Dollar direction from here
- We think the recent dollar sell-off has likely run its course and look for a rebound as we move into the early portion of 2023.
- But the second half of next year could see some dollar weakness as inflation falls and the Federal Reserve (Fed) reduces interest rates.
Until recently, the U.S. dollar had been in a meaningful uptrend since late-May of last year. Since then, against the euro, the dollar has gained a touch more than 15% at the time of this writing. At its peak in late September, the dollar was up more than 21% against the euro. The run-up has also been robust against the yen. The dollar has gained 27% against the Japanese currency over the same time frame and topped out just above 150 yen to the dollar just a handful of weeks ago.
The reasons for U.S. dollar strength have been well documented. The dollar typically holds a “perceived safe-haven status” in perilous and uncertain times. Some regions of the world, such as the eurozone, may already have fallen into recession. Others, such as the United States, are expected to see economic contraction in the new year. Virtually all of the major global central banks have been hiking interest rates in an effort to slow demand and knock the highest inflation in decades down to more acceptable levels. We continue to look for the Fed to once again hike the fed funds target rate, this time by 50 basis points (100 basis points equals 1%), at the December monetary policy meeting. We also believe a hike at the January 2023 policy meeting is likely.
Economic growth and interest-rate differentials also often drive currency strength or weakness. Although the domestic economy is slowing and inflation is high, one has to remember that currencies trade on a relative basis. Major economies like Japan and economic regions like the eurozone have largely slowed more quickly than the U.S. and their respective central banks have been slower than the Fed to move up interest rates in an attempt to bring down inflation. Higher relative interest rates, more dependable (but slowing) relative economic growth and the perceived safe-haven status have all helped attract dollar buyers at the expense of most other major currencies.
We believe that the recent pullback in the dollar is overdone and unlikely to have much follow-through from here. We look for the dollar to gain back some ground in the near term and into the initial months of 2023 as the underlying fundamentals and interest-rate differentials continue to favor the U.S. currency. But we believe the US is likely past peak-inflation and the Fed is going to move forward with smaller hikes. Other major economies continue to grapple with higher inflation and their central banks are earlier in the rate-hiking process than the Fed. However, we do not expect the dollar to reverse course to any meaningful extent until inflation falls closer to the Fed’s target and we are closer to interest rate cuts which we believe will occur in the second half of next year. A stronger dollar will continue to be a headwind for U.S. corporates with foreign sourced revenues. In addition, the rest of the world sees higher imported inflation with a stronger dollar which in turn may prod foreign central banks to increase interest rates more aggressively.
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