Further dollar weakness ahead
With 0.1% versus an expected 0.3% mom and 7.1% versus an expected 7.3% yoy, US consumer prices growth slowed further in November, surprising once again to the downside. Following the release of the numbers, the DXY dollar index slid by more than 1%. Year to date, the dollar has closely followed UST 10y yields, which were on an upward trend until October hence constituted the primary source of dollar strength in 2022. Yet the recent moderation in US consumer prices has changed the market narrative of Fed policy rates peaking well above 5%. Anticipating a slowing hiking cycle, the retracement in US rate expectations was particularly pronounced, which has led to a drop in UST yields across the curve and reversed the dollar upward trend.
While we acknowledge that dollar weakness kicked off a bit earlier than we had expected, the currency’s move broadly follows historical patterns. In particular, the dollar is mimicking the dynamics it showed throughout the past two Fed rate hiking cycles – 2004-06 and 2016-18. During both episodes, the dollar embarked on a downward trend well before the Fed policy rates reached their peak.
In spite of the recent weakness, the dollar’s real effective exchange rate reveals that the currency has remained very strong by historical standards. And from a current account perspective, the picture is similar, while the misalignment with fundamentals has moderated as of late. In combination with a US cycle that is potentially slowing fast, this suggests that the dollar weakness trend is likely to extend into 2023. This begs the question which dollar pairs will move most.
Over the past weeks, EUR-USD has seen a remarkable recovery, driven by improving euro area sentiment – reflective of the diminished likelihood of a European energy shortage and easing global supply pressures. The recent move has diminished the gap between exchange rate and short-term yields. Yet we do not expect the gap to close completely given that it partly represents the deterioration in Europe’s energy terms of trade, which are unlikely to reverse anytime soon. On the back of a cold December, gas prices have inched higher again. Moreover, the war in Ukraine and slowing industrial production are set to remain challenges for the euro. As such, we do not expect EUR-USD to rise much further from here.
In our view, USD-JPY will move most in 2023. Contrary to other developed economies, Japanese inflation prints continue to inch higher, which increases the odds for a BoJ policy shift in 2023. We think that the BoJ is likely to abandon its yield curve control in the second half of 2023, when it sees more evidence of Japanese wages picking up. We expect a narrowing UST-JGB yield differential to reverse much of the yen’s year-to-date decline versus the dollar.
The Swiss franc should remain a good place to be. Due to low domestic inflation (Swiss inflation is lower than in any other G10 economy), Swiss real yields are much more attractive than those of their euro area counterparts. What’s more, Switzerland’s economy is relatively resilient to a weakening US economy. This is reflected in a negative correlation between ISM and Swiss franc, which should push USD-CHF lower.
Within the group of commodity currencies, we think the Australian dollar should do comparatively well as AUD-USD valuations look historically cheap. Given China’s importance as a trading partner to Australia, the currency should benefit from a pickup in Chinese activity on the back of China’s COVID reopening.
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