But while current uncertainties have benefited the US dollar, the DXY index is still down around 10% from its September 2022 peak, and we continue to expect the US dollar to weaken against key counterparts over the next 6–12 months.
Any safe-haven boost to the US dollar from the debt ceiling impasse should be short-lived. While political wranglings over the debt ceiling have historically generated plenty of headlines, the impact on the US dollar has been fleeting. Foreign exchange markets are forward-looking and will assume Congress will agree to a last-minute deal, in our view. We are confident Congress will come to an agreement and expect safe-haven inflows to reverse.
The US rate-hike cycle is nearing its end, while Europe still has room to go. Recent comments from Federal Reserve officials have been more hawkish, calling into question the market assumption that there will be a pause in rate hikes at the June policy meeting. The Richmond Fed's Tom Barkin told Reuters on Monday that he is open to a pause or hike at the next meeting, and that more Fed action might be needed to constrict demand.Minneapolis Fed's Neel Kashkari warned against getting “fooled by a few months of positive data” and said the Fed probably has more work to do on inflation.
Despite this, the Fed is still closer to the end of the hiking cycle than the European Central Bank, in our view. Following this month’s meeting, the Fed gave its clearest signals yet that a pause was not far away. In the statement accompanying its May policy gathering, the central bank removed wording in previous versions stating that “additional firming may be appropriate.” While the Fed has signaled willingness to pause, ECB President Christine Lagarde has warned that there was “more ground to cover.” She noted that “we are not pausing, that is extremely clear.”
A reduction in the US yield carry and a reversal in Europe’s terms of trade should be key headwinds for the US dollar in the second half of 2023. Relative interest rate differentials are moving in favor of the euro. The premium offered by 2-year US Treasuries over 2-year US-Germany Bunds has narrowed to about 1.4 percentage points, from about 2.8pps in August 2022. The market focus on potential interest rates cuts in the US toward year-end and in 2024 could intensify in the coming months and will likely push US yields down further. In addition, the euro is benefiting from an improvement in the region's trade balance due to falling energy prices.
So, we advise investors to hedge their long USD exposure, and we maintain a least preferred view on the US dollar in our global strategy. We are most preferred on the Japanese yen and Australian dollar. To hedge against US dollar downside and rising recession risks in the US, we continue to recommend buying gold, as we forecast the gold price to reach USD 2,200/oz by March 2024.
Main contributors - Mark Haefele, Thomas Flury, Krishna Goradia, Daisy Tseng, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Position for renewed US dollar weakness, 16 May 2023.