While the dollar index is still 5% up from a low in the middle of July, recent trading highlights the potential for a weakening of the US currency. (ddp)

The DXY index, a measure of the US currency’s performance against six major peers, fell 0.5% on Monday, its first decline in eight sessions, having been on track for a larger drop earlier in the day.

The yen was a notable focus for US dollar weakness, with the Japanese currency rising 0.9% following hawkish comments from Bank of Japan (BoJ) Governor Kazuo Ueda, who said the central bank might have sufficient data by the end of the year to exit its ultra-easy policy stance.

While the dollar index is still 5% up from a low in the middle of July, recent trading highlights the potential for a weakening of the US currency:

The euro, the largest component of the DXY index, should benefit from a narrowing rate gap with the US. While both the Federal Reserve and the European Central Bank face finely balanced decisions on whether to raise rates further, we believe tightening is more likely in the Eurozone, where core inflation has been slower to come down. That is despite more tepid data on economic activity in the Eurozone. Markets have been pricing an increasing likelihood that the ECB will deliver a hike at this week's meeting, and overnight index swaps now give this outcome a 41% probability. That is up from a low of 23% at the start of this month. In addition, we think negative economic surprises in the region are already priced into the currency’s valuation, and the Eurozone’s improving trade balance should be supportive.

Ultra-easy monetary policy could end in Japan sooner than expected. A common view among economists has been that the Bank of Japan will exit its yield-curve control (YCC) policy by the second half of 2024. Recent comments from the central bank have increased the potential for an earlier policy shift. We had been anticipating more verbal intervention from the Japanese authorities to stem the yen’s decline, with the dollar having gained more than 12% against Japan's currency so far in 2023. The wide rate differential between the US and Japan has been a key driver of yen weakness, so any move to close this gap would send a strong signal to investors positioning for more yen declines. We expect the dollar to fall back to around 142 against the yen by the end of the year, versus 147 at present.

China’s central bank should continue to lean against the dollar’s rise versus the yuan. The Chinese currency, which is not part of the DXY currency index, could come under further pressure into the end of this year. We still think the exchange rate with the dollar could trade in a wide range for a while. However, there are early signs that growth in China is stabilizing. The central bank has also indicated it is averse to an excessive depreciation of the currency, saying in a statement that foreign exchange market participants should “resolutely avoid behaviors that disturb market orders such as conducting speculative trades.” We forecast the USD to end 2023 at 7.4 versus the yuan, compared with 7.28 at present, easing to 7.2 by March next year and to 7.0 by September 2024.

So, against this backdrop, we keep the US dollar least preferred, despite some near-term upside in the currency. We are most preferred on the euro.

Main contributors - Solita Marcelli, Mark Haefele, Thomas Flury, Christopher Swann, Teck Leng Tan, Vincent Heaney, Jon Gordon

Original report - Dollar looks vulnerable again, 12 September 2023.