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US Dollar: Is it time to call a top?
Summary: While the USD momentum has ruptured in the last few days due to increasing hawkishness of the European Central Bank and a strong verbal intervention by the Japanese authorities, there is potentially more room for the US dollar to run higher as Fed’s hawkishness can still outpace other global central banks. We need risks on Europe and China become more manageable, or a stronger opposition from non-US officials, or the Fed’s acceptable of a higher inflation target to really call it a top in the US dollar.
It is no surprise that the US dollar hit a fresh record high on the back of aggressive tightening by the Fed as well as safe-haven flows from global economic deceleration concerns. The greenback reached post-Plaza highs, with the DXY index rising above 110, the highest levels since June 2002. However, the tide turned at the end of last week, possibly as other major global central banks upped the ante on rate hikes as well. The European Central Bank (ECB) raised rates by 75bps despite clear risks of a recession, and there was also chatter that the ECB could consider quantitative tightening by year-end. Meanwhile, Japanese authorities grew concerned about the weakness in the yen, and gave out stronger verbal guidance in yen’s defence. On the geopolitics as well, there were reports that Ukraine surprisingly recaptured a key northeastern city from Russia and is also making advances in the south, so there are talks that this could be a turning point in the war. That potentially reduced safe-haven flows to the dollar, and boosted the EUR and GBP.
This week, however, brings the focus back on the US and the Fed. Tuesday’s US CPI data is the last data point of note before the Fed meets next week. A 75bps rate hike is baked in for the decision due on September 22. A positive surprise on US CPI may mean further upward repricing of Fed’s expectations with the terminal rate pushing above the 4% mark next year and easing expectations being pushed out further to late next year or 2024. That will support further gains in the dollar, with US yields running higher.
But a strong USD is not always favourable. Corporate earnings take a direct hit from the rising dollar, given that most US companies generate a substantial part of their earnings outside the US. While most companies apply some FX hedging strategies, historically large upward swings in the USD have led to negative earnings revisions with a 9-12 months lag. The US also has a broader strategic objective to expand its manufacturing sector, and a strong US dollar could bite into the competitiveness of the sector. But for now, we do not see enough reasons for the dollar rally to cease or turn. The macro environment where the Fed acknowledges and is ready to take action further to slow US demand and bring inflationary pressures into balance suggests further gains for the dollar remain in store, atleast into the end of 2022 or into early 2023.
A few things need to change before we can call it a top in US dollar:
- Fed has to slow down the pace of rate hikes, with possible recession on the cards or a capitulation in equities. The US economic data has been holding up strongly and there is no sign yet of a capitulation in equities even as the sentiment turned overly bearish last week. On a relative basis, there is still more reasons to believe that the tightening cycles for ECB and BOE may be repriced lower, while the Fed will need some more upward repricing.
- Risk of stagflation in Europe and UK needs to ease. The EU emergency summit did not see consensus build on securing energy supplies and a tough winter is still ahead. There has been some respite on the military front, but that can remain volatile and likely to result in further pressure from Russia on European gas supplies.
- Meanwhile, China needs to part with its zero covid policies, which is unlikely to happen before next year at least. In addition to the covid policies, China’s property sector overhang and resultant confidence deficit suggests more CNY pressures in the pipeline that defers to a further bullish USD trend. The People’s Bank of China seems to be happy with a controlled CNY depreciation.
- Other non-US officials need to start getting concerned about the weakness in their currencies. The biggest loser on the G10 board this year has been the Japanese yen. Japanese authorities have shown some concern about the weakness in the yen, but we only saw a mild recovery in the Japanese yen. The yield differentials between US and Japan will continue to underpin further gains in USDJPY. Even if the Japanese authorities were to directly intervene, it will only increase the volatility. The only catalysts for the yen to reverse its losses is lower US yields or Bank of Japan tweaking its yield curve control policy.
- A change in Fed’s inflation target to 2-3% in the medium-term. Fed will possibly have to begin quantitative easing for the weakness in the USD to stick.
How to get exposure to the US dollar?
To get exposure to the US dollar, one can consider the following instruments:
- Directly getting exposure to the Dollar Index through futures (DXU2) or CFDs (USDINDEXSEP22)
- Through ETFs such as WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU:arcx) or Invesco DB USD Index Bullish Fund (UUP:arcx) or BetaShares US Dollar (USD:xasx)