Overview: The outlook for the dollar
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The US dollar (USD) has had a period of remarkable strength since mid-2021, gaining against almost all currencies during this time and notching multi-decade highs against some of them in the process. This analysis examines some of the factors that we believe caused this surge in the greenback, and why we believe the currency may be rolling over into a new downward phase. Factors spurring USD strength over the past period included growth differentials in favor of the US compared to other regions, a continued hawkish reassessment of the US Federal Reserve’s (Fed’s) interest-rate path during 2022 and some spillover effects from the Russia-Ukraine war. However, despite these past supportive factors, we believe the USD overreacted, and the sheer extremes of the market moves seen thus far lead us to believe the USD remains significantly overvalued. This conclusion is sharpened by an assessment of how we expect relevant fundamental factors to unfold going forward. While we believe the USD is overvalued against a number of global currencies, in this report we focus on a USD reversal compared to Asian currencies, which we see as generally having particularly strong fundamentals.
Where we’ve been…
The USD had an impressive rally from the second half of 2021 until late 2022 as the US economy outperformed other major world economies. It proved more resilient than many had expected, partly due to a still-robust labor market. At the same time, inflation accelerated well past the Fed’s target and compelled the Fed to respond with aggressive rate hikes. The consequent continued ratcheting up of market expectations for the fed funds rate appears to have had a significant supportive effect on the USD.
Part of the backdrop since early 2022 included the Russian invasion of Ukraine and consequent war between these two countries, which resulted in some perceived safe-haven flows into the USD, along with effects on the economic factors mentioned above. Europe was more directly and more negatively affected growth-wise than the US, exacerbating the growth differential between the two regions. Meanwhile, the effects of the war and subsequent sanctions—which significantly affected both global energy and food prices—pushed inflation higher globally as well. Rising inflation rates in the US, as well as its central bank response, led those seen in the euro area, helping support the USD against the euro.
In Asia, the Bank of Japan (BOJ) kept monetary policy unchanged almost all year, widening the interest-rate differential with the US, until a December change to the target band around the 10-year government bond yield. Most of Asia ex Japan had relatively low inflation rates compared to the US and Europe, and thus saw a more gradual monetary policy tightening. At the same time, most Asian countries adopted, to greater or lesser degrees, a more cautious approach to reopening after COVID than the US had. The combined effects of these factors on interest-rate and growth differentials generally helped support the USD against Asian currencies. This environment led to a sharp appreciation of the USD, particularly against major developed country currencies. In our view, this appreciation has led to a significant overvaluation of the USD, especially against the Japanese yen (JPY), and to a lesser extent against other currencies.
The DXY dollar index is close to two-decade highs at the time of this writing (Exhibit 1), and various other dollar indexes— whether broad or narrow—are all showing the same message of multi-year highs (Exhibit 2 on the next page).
…and where we’re going
We believe the tide will turn—if indeed it has not already started doing so, as early indications from market moves in December 2022 suggest. After relatively impressive growth in the US over prior quarters, the US economy is slowing. It is now expected to grow more slowly than some other major economies in 2023, and especially so compared to a number of Asian economies. Indeed, 2023 is one of the rare years for which the International Monetary Fund (IMF) forecasts growth in Japan to exceed that of the US (see Exhibit 3). The Fed’s rate tightening since the first half of 2022, even though delayed in response to rising inflation, is already a headwind to US economic activity, particularly for interest-rate sensitive sectors like the housing market. The US inflation outlook implies that the Fed could first slow and then halt rate increases. Both demand-side and supply-side factors will help ease inflation—we believe US inflation is already past its peak—but inflation is also likely to remain well above the Fed’s 2% target for some time. As the economy slows and labor market tightness lessens, core inflationary pressure should continue to gradually ease. Furthermore, we see supply-chain bottlenecks easing, while energy prices and food prices are stabilizing and even decreasing in nominal terms
In contrast to a softening business cycle in the US, we see signs of certain economies moving into expansionary phases elsewhere, especially in Asia. The two biggest economies in the region, Japan and China, are moving past the early stages of reopening after their prior strict COVID shutdowns. Macro polices are also supportive of growth, in contrast to some other regions. This means domestic demand will likely reinforce still-robust export growth to support economic expansion in the region. At the same time as the business cycle is significantly softening in the US, larger Asian economies are likely to be far more resilient, which should also benefit smaller Asian economies.
We see the biggest driver of the USD rally during this past year as having been the unexpectedly fast increase in the US fed funds rate; we now believe market expectations more appropriately reflect its terminal rate, when the Fed will cease raising interest rates. In tandem with that, we expect a number of currencies, especially in Asia—with its dynamic and diverse economies and with their stronger external and/or fiscal balances than those of the US—to outperform the USD in 2023. Our key conclusion is that we expect global asset markets this year to mark the fall of the USD in favor of, especially, Asian currencies. Some risks to this outlook include an escalation in geopolitical tensions between the US and China, idiosyncratic factors in particular countries, and any significant deviation from expectations in US interest rates.
