Chief Investment Strategist
Summary: With the Fed turning markedly more hawkish this week, along with other key central banks such as Bank of England and Norges Bank adding to the list of central banks taking dovish paths, there is potentially scope for another leg higher in the US dollar. A short-term peak in the greenback will only be seen when markets fully price in the Fed path, while a turnaround will have to wait for a shift in US economic data trends. Still, even mounting recession concerns will drive safe-haven flows to US assets.
The strength of the US dollar has been the biggest talk of town this year. After a steady increase since 2008, the USD was already in a strong position at the start of the year, but it has gained a further over 17% year-to-date. Questions like when will the USD peak or has it reached a top have been on investors’ minds, and we have often pushed back on these expectations.
My previous piece on the US dollar highlighted that a few things may need to change before we call it a top in the USD. These included a possible peak in the yield differential between the US and other Developed Markets, or China to part with its zero Covid policies. Both of those factors, for now, have turned further in favour of another bout of USD strength.
Fed Chair Powell surprised hawkish at the FOMC meeting this week, managing to reverse the dovish sentiments that developed following the press release. Pivot hopes were crushed, with the only pivot coming through being hawkish to more hawkish.
Even as the Fed moves to a smaller pace of rate hikes from here, it has guided for a higher terminal rate compared to the median projection of 4.6% as per the September dot plot. This has sprung fresh strength in US yields, with 2-year printing fresh highs of ~4.75% and 10-year yields inching above 4.20% as well. In fact, the doors to 10-year yields reaching 4.75-5% have been opened with Fed’s terminal rate projections now above 5.1%.
This, alone, has the potential to spark a fresh wave of strength in the US dollar. However, to add to the mix, we now have most other DM central banks taking the less hawkish route. This began with the Reserve Bank of Australia stepping down to smaller rate hikes in October, as it highlighted concerns around consumer household budgets. This was followed by dovish hints from the European Central Bank and the Bank of Canada.
The latest ones from yesterday, Norges Bank and Bank of England, also surprised dovish. With expectations split between a 25 or 50bps rate hike, Norges Bank took the dovish path and hiked 25bps despite a deteriorating inflation outlook. Bank of England, despite a 75bps rate hike on Thursday, strongly pushed back against expectations for the scale of future moves, saying that the terminal rate priced in currently by the markets would induce a two-year recession. There were also two dovish dissenters at the meeting, one calling for 50bps rate hike and another for a mere 25bps. Markets are still pricing in more than a 50bps hike for the BOE’s December meeting, but expect this pricing to pare back as we approach December.
This upward re-pricing of the Fed rate path, together with a downward re-pricing of expectations from other DM central banks is clear indication of further room for the USD to run higher.
While there was some speculation this week that China could start to consider ways to part with its Zero Covid policy, none of that has been confirmed by the authorities. If we do see the China economy open up, that suggests commodity prices could bump higher as China demand comes back online. That should support the commodity currencies such as AUD and NZD, and also bring in a recovery in the Chinese yuan. But any massive shifts or significant steps to open up the economy are unlikely in the near term, and these will likely remain subtle at best. A dynamic Zero-Covid policy is likely to stay for now, potentially with some flexibility around quarantine requirements or PCR tests.
The US economy still remains in a position of strength, with a strong labor market and significant household savings. This, in comparison to rising recession fears in the EU and the UK, suggest that capital flows will continue to be fuelled towards the safety of US assets. Even if we see a mild recession in the US, markets will be scrambling for liquidity which is usually found in US dollar or the US Treasuries. A temporary peak may be seen in the USD later in Q4 or early Q1 as Fed’s upward pricing reaches a peak, but still, a turnaround in the USD will be slow and stretched.
In the short run, a peak in USD would be a result of a near peak in pricing in the Fed rate path. But a more sustainable trend lower will have to wait for US economic data to show a materially different trend. Say core PCE down to 0.1-0.2% MoM levels or labor market materially cooling with NFP gains down to about 100k or so.
Another leg higher in the USD will mean further pressure on Asian FX, especially the Chinese yuan which is facing policy divergence to the Fed and a slowing economy at home. Other tech-exposed currencies like the Korean won (KRW) and Taiwanese dollar (TWD) may be under greater pressure as well, although relative resilience can be expected for the safe-haven Singapore dollar (SGD). The Indonesian rupiah (IDR) will also likely be supported if Bank Indonesia adopts a fast pace of tightening, as a favourable current account situation also lends support.
Long USD and short risk assets is perhaps still the most favourable strategy. We previously listed out tools that can be used to go long US dollar here. In the FX space, this can be traded using options as well with potential short positions on GBP, EUR, TWD, KRW.
Also, consider that upward pricing of Fed’s rate path from here can mean short-term headwinds for Gold and Silver. We still expect medium-term upside in precious metals, however, as inflation expectations remain anchored higher in the new deglobalized world.
Meanwhile, a lower pace of Fed rate hikes from here could reduce volatility in the interest rate markets, so watch the MOVE index. This could potentially lower the volatility in the FX markets as well. We believe a peak in bond volatility will be the key, and the first sign, for the markets to reverse trend.
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