Upgrading our US dollar view

Elevated interest rates and robust economic growth in the US relative to the rest of the world have broadly supported the US dollar over the past two months. While market pricing for the Federal Reserve’s terminal policy rate has been relatively stable, the implied pricing for rate cuts next year fell after the Fed signaled that rates may stay higher for longer.

From a recent low in mid-July, the US dollar has appreciated by around 6% against the euro, with the dollar index, a basket of six major currencies, rising by a similar amount. We now think that the greenback will stay well bid until end-2023 and move the US dollar to neutral from least preferred. Similarly, we move the euro to neutral from most preferred and change our forecasts across key currency pairs.

• Higher-for-longer US rates support the US dollar… With inflation rolling over globally, we expect central bank policy rate hikes to be finished by 4Q this year, with the market now looking at how long current rates are likely to be sustained in 2024. Reflecting a backdrop of higher US rates for longer, we think the US dollar is likely to remain supported into the year-end.
• …so too does resilient US growth… The underlying economic growth story is another important currency driver. Where investors are confident that the underlying economy can manage current interest rate levels, we expect the respective currency to be well bid. GDP growth in the US has held up much better than expected and compared to other countries, although signs of slowing are emerging.
• … in contrast, Europe and China have disappointed. Economic data out of Europe and China have been soft and have not lived up to market expectations. For markets to regain their confidence in those economies and currencies, good news on growth is needed. Particularly for Europe, we think an immediate turnaround is unlikely. For a new goods-linked restocking cycle in the developed world to begin, positive macro data or a decline in energy prices (natural gas and oil) needs to materialize. But we expect neither driver to do so through the rest of this year.

Until the year-end, we now expect the US dollar to trade sideways against most currencies. We now forecast EURUSD, USDCHF, and GBPUSD to trade at 1.06 (previously 1.12), 0.92 (0.87), and 1.20 (1.29), respectively, by end-December. And in Asia-Pacific, we see USDJPY and AUDUSD trading at 145 (previously 142) and 0.65 (0.66), respectively, by end-December.

The near-term risks are skewed toward additional US dollar strength, in our view. Given the latest macroeconomic data, it has become questionable whether the Fed needs to cut policy rates before the European Central Bank. Hence, there is risk that the USD might gain further ground versus the EUR, and EURUSD could slip back below 1.05.

In the near term, we prefer to use the options markets for yield pickup when it comes to the US dollar, while investors should consider gainers from higher energy prices (Norwegian krone, the Australian dollar, or the Canadian dollar) in the crosses. We also recommend seeking selective exposure to emerging market currencies with a high yield.

But looking further ahead, relative growth dynamics are likely to run against the US dollar in 1H24. US economic activity should take a step down, as we expect excess savings to be used up by the year-end and higher interest rates to weigh on US consumer spending. In short, the US economy has yet to bottom, while Europe and China already have, in our view. We expect US dollar strength to peak next year and the greenback to give up some gains. We reflect this in EURUSD, USDCHF, and GBPUSD with our September 2024 forecasts at 1.12 (previously 1.16), 0.87 (0.84), and 1.30 (1.36), respectively. This view requires Europe to stay out of recession and China to stabilize.

Read more on our new US dollar view and on our FX recommendations in Currency markets: Reviewing the US dollar, published on 27 September.