The US dollar’s best days may be behind us

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The US Dollar Index (DXY) hit a near 20-year high in mid-May. Even after a recent retreat, the DXY is still up 13.3% over the past year and 6.3% year-to-date. This year's rally has been led mostly by an increasingly hawkish Fed as inflation reached its highest level in 40 years. A flight-to-safety due to global growth concerns over Europe and China has also buoyed the dollar.

But we think the USD rally has run its course, and we see limited upside from here.

Fed rate hike expectations are fully priced in. Markets are pricing in a move in US rates into restrictive territory, but there are early signs that key inflation rates are moderating. The Fed’s favorite inflation gauge—the personal consumption expenditures (PCE) index—rose just 0.2% month-on-month in April. That was the smallest gain since November 2020 and followed a 0.9% jump in March. The core PCE measure, which excludes volatile food and energy prices, has now climbed by 0.3% for the past three months. The year-on-year increase in the core measure, 4.9%, was the smallest since December.

Meanwhile, US 10-year breakeven inflation rates have dropped to 2.6% from 3% a month ago, indicating improved confidence in the Fed's ability to rein in inflation. This increased confidence that inflation has passed its peak has spurred markets to pare back their expectations of the Fed’s tightening this year. Fed funds futures now imply around 262 basis points (bps) of rate rises for 2022, versus a peak of around 285bps earlier in May.

Other central banks are starting to catch up on the tightening path. The European Central Bank has become less dovish, with President Christine Lagarde signaling the likelihood of at least 50bps of hikes by the end of September. Higher-than-expected Eurozone inflation readings for May of 8.1%—the currency bloc's highest ever—have added to the hawkish mood. This will give the Swiss National Bank (SNB) more scope to tighten. Historically, the SNB has had a clear commitment to stem inflation through currency appreciation. This was also the latest message by SNB President Thomas Jordan in preparation for the upcoming tightening shift.

The USD rally has exceeded our expectations. While we have guided for short-term USD strength since the start of the year on the back of the Fed’s tightening cycle, the magnitude of the appreciation has exceeded our expectations, as the Fed turned increasingly more hawkish. In addition, growth concerns in China and Europe, as a result of COVID-19 outbreaks and the war in Ukraine respectively, have also spurred safe haven flows into the greenback.

We now see the risks to the greenback as being more balanced, especially against the Swiss franc and the Japanese yen, both of which are also traditional safe haven currencies. Any worsening of geopolitical concerns should support those two low-yielding currencies.

Further, we see another 10% upside in broad commodity indexes over the next six months, supported by structural imbalance, bans in various forms (sanctions, export restrictions) and weather risks. This bodes well for commodity-linked currencies against the USD.

So, we have lowered our USD preference to neutral. We expect any further USD gains to be modest and short-lived. We are no longer negative on the Swiss franc, with the outlook more balanced due to the SNB's renewed focus on inflation. That said, despite the ECB’s plans to begin rate hikes, we see limited gains for the euro due to economic headwinds. Instead, we favor commodity-linked currencies including the Australian dollar, New Zealand dollar, Norwegian krone, and the Canadian dollar, which should benefit from stronger investment activity and improving balance of payments positions.