Probably not just yet. Heading into 2023, the baseline outlook still calls for dollar strength, but of a lower magnitude and different composition than in 2022.
After a year of aggressive hiking and with another increase due in January 2023, the Fed will likely hold its policy rate and monitor the economy to see the full effect of its tightening so far. This pause should give the dollar’s rise a breather. Additionally, unlike in 2022, lower-yielding currencies like the euro are expected to be more insulated as central banks pause hikes and the focus shifts to addressing slowing growth — but this in turn makes high-beta, emerging market currencies more vulnerable.
“Ultimately, a Fed pause is not a sufficient condition for dollar weakness. USD performance around the last four Fed pauses was not consistent and depended on the macro context at the time,” said Meera Chandan, Global FX Strategist at J.P. Morgan. For instance, when inflation was rampant in the 1970s, the dollar weakened in the months prior to the Fed pause and then strengthened again when inflation persisted. “What’s more, U.S. recession risks are high, and this is USD-supportive,” added Chandan.
The dollar already yields more than 56% of currencies globally —
and the Fed isn’t done hiking yet
Source: J.P. Morgan
While the dollar’s carry prospects have fluctuated over the past two decades, it now yields more than 56% of currencies in the global universe as of 2022.
Weak growth outside the U.S. will also remain a pillar of USD strength in 2023. “Some growth signals suggest an improvement outside the U.S., but we are skeptical of the longevity of this theme,” said Chandan. In the Euro area, the primary vulnerability remains energy dependence. For China, the hope is that 2023 will be a year of normalization as the country finally moves away from zero-Covid and as pragmatic policy support fosters some stabilization in the bruised real estate sector — but the road ahead is challenging.
In addition, the carry trade landscape will continue to favor the dollar. Simply put, a carry trade involves borrowing a low-yield currency to buy a higher-yield currency in order to profit from the difference in interest rates. In 2022, the Fed’s aggressive stance dramatically transformed USD’s carry status, with 56% of global currencies now yielding less than the dollar — and the Fed has not yet finished its hiking cycle. This offers investors an incentive to own dollars in 2023, particularly versus low-yielding, high-beta currencies.
Overall, while there are several possible pushbacks to USD strength from outside the U.S. — including negative growth surprises, the policy response to Europe’s energy crisis and currency interventions — the outlook for the dollar remains bullish into 2023. “We forecast a relatively modest 2% strengthening of the broad dollar index from current levels,” said Chandan.