US economy Dollar strength has further to go

The renewed rise in the DXY index—to less than 1.5% below its multi-decade high in September, or a gain of more than 17% so far this year—puts the dollar on track for its largest yearly advance on record.

Despite the magnitude of these gains, we expect the dollar's strength to persist in the near term, due to both tailwinds propelling the currency and headwinds facing its major peers.

The Fed remains more aggressive in raising rates than other major central banks. While Fed Chair Jerome Powell hinted at a slower pace of rate increases at some point, he made clear that the Fed’s efforts to bring down inflation remain unfinished. He added that data since the last policy meeting in September “suggests that the ultimate level of interest rates will be higher than previously expected.” Last month, the US core personal consumption expenditures (PCE) price index rose 5.1% year-over-year and 0.5% month-over-month. We continue to think the Fed will need to see at least three months in which core PCE comes in at or below 0.2% month-over-month before backing away from its hawkish stance. This week, US monthly job openings jumped and weekly jobless claims unexpectedly fell, which also points to a still tight labor market.

The challenging UK economy casts a cloud over sterling. The pound fell 2% against the US dollar after the Bank of England raised rates by 75bps on Thursday. While this was the largest rate rise in 30 years from the central bank, the pound's fall partly reflected dovish aspects to the policy statement, which indicated that rates could “peak lower than priced into financial markets.” In addition, two of the nine members of the Monetary Policy Committee favored smaller rate rises, with one wanting 50 basis points and another 25 basis points. The pound's vulnerability also reflects the nation’s challenging macroeconomic environment. There is a high likelihood that the UK will enter a recession in the coming quarters while inflation stays elevated. We think that GBPUSD is likely to swing around 1.10 in the coming months.

The yuan is likely to stay weak in the near term, given macro headwinds and the large USD yield advantage. The Chinese yuan has been under pressure in part because of the disappointing pace of China’s recovery, as the government persists with its economically damaging zero-COVID policy. In addition, the continued divergence in US-China monetary policy and the subdued appetite for Chinese assets will see persistent, upward pressure on the USDCNY in the near term. Our guidance to hedge CNY long exposure into 1Q23 remains in place.

So, we keep the USD as most preferred in our currency strategy as the Fed’s rate hiking cycle continues. We also favor the Swiss franc as its safe-haven appeal is likely to attract inflows against the backdrop of a European recession and the Swiss National Bank’s willingness to let the franc appreciate.

Main contributors - Mark Haefele, Thomas Flury, Daisy Tseng, Vincent Heaney, Alison Parums

Content is a product of the Chief Investment Office (CIO).

Original report - Dollar strength has further to go, 4 November 2022.