Continued Slow Erosion, From Shifting Headwinds

On my thoughts, it's evident that the US Dollar (USD) continues its gradual erosion, influenced by various shifting headwinds. Looking ahead to the entirety of 2023, indications point towards a mild depreciation of the Dollar, with estimates projecting a -1% decline based on the DXY and a broader trade-weighted index showing a decrease of -1.3%. According to my assessments, this still leaves the Dollar approximately 14-15% overvalued on a real trade-weighted basis. Notably, this represents a decline of around 5-6 percentage points from its peak overvaluation observed in the autumn of 2022. In simpler terms, as we approach the dawn of 2024, the Dollar seems poised to maintain its relative strength.

Considering the broader global macroeconomic backdrop marked by significant disinflation coupled with robust growth, non-recessionary Fed cuts, and an optimistic equity risk sentiment, my expectation is for this trend of Dollar strength erosion to persist, albeit at a relatively gradual pace. This is largely driven by the fact that, on a global scale, disinflation and rate cuts are anticipated universally. However, the US stands out with its seemingly assured economic growth and consistently favourable returns in its asset market.

In the foreseeable future, my year-ahead FX forecasts suggest an additional 2%-3% depreciation of the Dollar over the next 12 months, signifying a further weakening of its robust valuation. Despite this, it's plausible that we might still find ourselves in a scenario of a strong Dollar for at least another year. What's interesting to note is that despite the similar headline Dollar returns, the dynamics beneath the index are likely to exhibit significant variation. In the recently concluded 2023, movements against the Dollar were distinctly region-specific, with notable appreciations in the Americas (MXN, BRL) and considerable depreciations in Asia (JPY, CNY), while European crosses exhibited a relatively stable trajectory.

Looking forward, I anticipate a more widespread Dollar depreciation in the coming year, with pro-cyclical currencies benefiting from a softer landing (including KRW, ZAR, AUD, NZD, and GBP). However, this potential depreciation is expected to be restrained by major currencies such as EUR, CNY, and JPY. Factors like sluggish activity in the Euro-area, persistent structural challenges in China, and a gradual NIRP exit in Japan are likely to limit substantial capital flows away from the US toward key challenger currencies—EUR, CNY, and JPY. Despite expecting further progress, it's worth noting that replicating the double-digit appreciation observed in currencies like MXN, COP, BRL, and PLN may prove challenging due to valuation considerations and a shifting policy mix.

In summary, both the top-down and bottom-up perspectives converge to support the expectation of lower-volatility movements. This aligns seamlessly with my relatively favourable outlook for the global economy, where 'benign' conditions often correlate with reduced FX volatility. Nonetheless, I acknowledge the potential for higher volatility in FX markets next year, which could arise from deviations from this baseline scenario. While my baseline view suggests a relaxation of risks from the Fed as more of a policy choice than a necessity, the evolving landscape prompts a prudent approach, acknowledging the potential for unforeseen developments that may warrant careful consideration and protective measures.

This content may have been written by a third party. ACY makes no representation or warranty and assumes no liability as to the accuracy or completeness of the information provided, nor any loss arising from any investment based on a recommendation, forecast or other information supplied by any third-party. This content is information only, and does not constitute financial, investment or other advice on which you can rely.