USD After a Sharp Sell-off Some Overdue Recovery

In my analysis of the Q1 and Q2 US dollar forecasts, I emphasize the potential for the US dollar to recover some of the significant losses experienced in the months of November and December. As an analyst, I recognize the inherent uncertainty surrounding foreign exchange movements during the turn of the year, given the possibility of position adjustments and exaggerated moves amid abnormal liquidity conditions.

Drawing attention to historical trends, I note that, contrary to typical patterns, last year saw the EUR/USD pair retracing after an 8% gain in Nov/Dec 2022. Despite the usual seasonal bias where the start of the year tends to be the worst period for performance, EUR/USD ended January a further 2.8% higher. The 2-year UST bond yield also experienced a notable drop in January 2023, declining by as much as 35bps due to receding inflation risks and a more significant slowdown in wage growth than anticipated in the NFP report for December 2022.

Source: Prime Market Terminal (PMT)

Considering the importance of fundamentals, it becomes evident that while a retracement of the Nov/Dec weakness in the dollar may occur, the movement of yields in tandem with US dollar weakness could diminish the significance of the seasonal bias. However, my view is that the scope for yields to decrease further is limited, especially with the market already fully pricing in a 25bp rate cut in March.

To validate the potential for the US dollar to recover from the Nov/Dec sell-off, weak US data is crucial. If such data is not forthcoming in the coming days and weeks, the likelihood of a retracement of the Nov/Dec sell-off remains high.

Underlining the significance of the upcoming FOMC minutes from the December meeting, I note that this event fuelled the US dollar sell-off. During this meeting, FOMC members added an additional 25bp rate cut to the median dot profile for 2024, and Fed Chair Powell acknowledged discussions about the timing and extent of rate cuts in the current year. This aspect will be a focal point for the markets. The minutes' revelation regarding this discussion and any references to the considerable easing of financial conditions at that time will be crucial. Any mention of market moves equating to Fed rate cuts could impact market expectations, potentially delaying a rate cut as early as March.

In my assessment, there is a higher probability that the minutes will imply rate cuts coming later than March, posing a greater risk of disappointment considering the current market rates. Such a scenario could further contribute to the potential retracement of the Nov/Dec sell-off of the dollar as US yields recover.

While not expecting a significant market reaction, I acknowledge the importance of labour market data flow, including the JOLTS report today, the ADP report tomorrow, and the NFP on Friday. A lack of weakness evident in these reports would undoubtedly support the extension of the dollar rebound.

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