Turbulent Start: Dollar Surges in New Year, Unwinding Dovish Bets and Questioning Equity Valuations

FX Daily: A dollar rally to start the New Year

The dollar jumped yesterday as investors started to return from the long Christmas break. Markets are unwinding some dovish bets, and questioning stretched equity valuations, ultimately favouring defensive bets in FX. The dollar also tends to seasonally outperform at the start of the year. Today, the focus moves back to data, as well as the FOMC minutes.

 

USD: Dollar seasonally strong in January and February

Defensive bets dominated in global markets as investors returned from the long Christmas break. This was particularly evident in the FX market, as the dollar corrected sharply higher yesterday to the detriment of European currencies. The tendency of dollar selling and European FX buying that emerged in December was triggered by the dovish pivot at the December FOMC, but seasonal factors also played a role. The dollar tends to underperform at the end of the year, likely due to some tax-related flows from US corporations: DXY weakened in December in each of the past seven years. While the seasonality factor isn’t as strong, January tends to be a good month for the dollar, with DXY having risen on average 0.4% in the past 20 years. February has shown a stronger positive seasonality pattern, with DXY having appreciated in each of the past seven years.

The dollar strength in the early part of the year is often associated with the December tax flows by US corporates being reverted, and while expectations of a firmer dollar at the start of the year (which we agree with) could have exacerbated yesterday’s USD buying, the key factor remains Federal Reserve dovish bets against the backdrop of stretched equity valuations after a strong year for US stocks, in particular in the tech sector.

We have observed some tentative unwinding of dovish bets as trading resumed: interestingly, the Fed Funds futures curve no longer fully prices in a March cut (21bp at the moment). As trading volumes pick back up this week, US calendar events will also offer direction to investors. Today, the Fed releases the minutes of the December FOMC, which should shed some light on the reasoning behind the dovish revision of the Dot Plot. Given the strong dovish reception by the market after the December Fed announcement, there is a risk of the minutes preventing further dovish bets as some conditionality (in terms of economic data developments) for easing policy emerges in the minutes.

Today also sees the release of JOLTS job openings for November and the December ISM manufacturing, and consensus is positioned for a good print in both releases. We are inclined to think that the dollar can hold on to most of yesterday’s gains in the next couple of days, as data may prove benign and investors favour defensive positions ahead of Friday’s US payrolls – which are expected to print a respectable 170k. DXY may hover around the 102 gauge into the payrolls. Beyond the very short term, we still expect a further dollar decline to materialise this year as the deterioration in the economic outlook forces large Fed cuts, but the pace of USD depreciation should be more moderate in 1H24 compared to November/December 2023.