US dollar bulls could be skating on thin ice

Recent speculation that the Federal Reserve will raise interest rates significantly this year has boosted US dollar sentiment
However, with the jury still out on economy recovery and the Fed less likely to go for overkill on inflation, it won’t be too long before interest rate expectations level off

David Brown

Published: 9:30pm, 27 Feb 2023

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Don’t get your hopes up that the US dollar is enjoying a sea-change in fortunes. In fact, there is every chance dollar bulls are skating on thin ice after recent speculation that the US Federal Reserve is adopting a tougher guard against inflation.

The Fed seems set to take the key funds rate to a peak between 5 to 5.25 per cent in the next few months, but there’s still scope to ease policy before the end of the year to give the US economy a boost as the Fed’s focus switches from inflation to growth.

The dollar will lose its shine as interest-rate expectations level off, safe haven demand declines and investors seek better opportunities abroad. A weaker dollar might bring a welcome break for US exporters, but other nations might not be so happy to lose a vital source of export-led support.

It’s true that there has been some modest realignment in US interest rate perceptions in recent weeks as the economy has performed better than expected. US inflation fears have eased considerably and the economy is in a better place, but the Fed’s attention may now be focused on stronger-than-expected domestic demand, leaving little scope for the central bank to soften on its apparent commitment to toughen up policy.

US consumer price inflation has fallen quite sharply from 9.1 per cent in June last year down to 6.4 per cent in January, but booming employment conditions and a 3 per cent surge in retail sales in January have muddied the waters, challenging hopes about how soon US interest rates might eventually come down.

As inflation pressures progressively eased, US money market futures had taken a more dovish view of Fed policy intentions, looking for the funds rate to peak at 5 per cent in the next few months but with the possibility of lower interest rates creeping in before the end of 2023. More recently though, on the back of stronger real economy data, money markets have revised expectations for a possible peak in Fed funds up to 5.4 per cent, with little chance of a rate cut until 2024.

It’s provided a positive boost for US dollar sentiment, which has seen the trade-weighted currency index, representing the dollar against a basket of other major currencies, gaining ground to the tune of 4 per cent over the last month.

Whether this marks a major dollar reversal in the 11 per cent sell-off from the September 2022 peak to the recent 2023 low, or is merely a short-lived, false dawn, remains to be seen as the Fed fine-tunes its monetary message over the next few months.

What is clear is that the Fed’s main bogeyman, the risk of higher embedded inflation, looks a lot less menacing, providing policymakers more room to manoeuvre in the future. The US narrowly avoided deeper recession in 2022, but the economy is still not out of the woods, despite two successive quarters of recovery, with growth at 2.7 per cent in the fourth quarter of 2022 after 3.2 per cent in the previous three months.

With the jury still out on the recovery and the Fed less likely to go for overkill on inflation, it won’t be too long before a more dovish interpretation emerges again, US interest rate expectations level off and the dollar goes back to square one again.

With interest rates starting to normalise, the lacklustre economic outlook and the US’ poor budget and trade deficit fundamentals will leave global investors looking to higher-risk trades elsewhere as global stability continues to improves, barring any major escalation of the Ukraine conflict this year.

US President Joe Biden finishes speaking at the National Association of Counties 2023 Legislative Conference in Washington on February 14. Biden outlined his vision for the economy and urged Republicans in Congress to work with him to raise the US national debt ceiling. Photo: EPA-EFE

China’s renminbi could be a clear candidate for investors looking for attractive short dollar currency plays, especially considering some of the recent bullishness expressed over China’s stock market potential this year as the economy gets back into full swing after last year’s Covid-19 lockdowns.

China’s hard-pressed exporters would be extremely unhappy to lose competitiveness through a renminbi resurgence, which is already up 5 per cent on the dollar since mid-January.

If lower US rates are on the cards later this year, the dollar could go into a tailspin with the prospect of the renminbi rising back to 2022’s highs. With China’s exports already slumping by 9.9 per cent year on year in December, would Beijing stand idly by?

Critically, China’s dual circulation policy and the emphasis on domestic-driven growth should favour benign neglect rather than official currency intervention. A hands-off approach would be better received by investors too.

David Brown is the chief executive of New View Economics