US dollar 2023 outlook: Can the Fed convince markets that rates remain higher for longer?
Updated
2022 has been one of the US dollar's best years in the 21st century. That is especially true if you focus solely on the first three quarters of the year, which saw a 21% gain in the dollar index (DXY). The fourth quarter has been a completely different story so let’s have a look at what has happened so far this year.
US Dollar Index (DXY) 2021-2022 daily chart. Photo: capital.com. Source: tradingviewUSD: 2022 Year in Review
The year started with a build-up in bullish sentiment coming from the recovery from the 2021 lows. The first three months of the year saw steady gains for the dollar as traders started to position themselves for a more hawkish Federal Reserve that would start delivering interest rate hikes. This was mostly on the back of soaring inflation, which at first was deemed to be transitory by Powell and his team, but as the year passed it became obvious that this was not the case.
US consumer inflation peaked at 9.1% in June, its highest level since 1981 but even as we’ve seen prices rising at a slower pace since then, they are still rising and the YoY rate remains highly elevated. Throughout the year the focus of the Fed shifted from inflation, once they had acknowledged that it was indeed stickier than originally thought, to the labour market. After peaking at 14.7% in April 2020, the unemployment rate stabilised throughout 2020 and 2021, dipping below 4% at the start of this year. The monthly Non-farm Payrolls (NFP) data served to confirm that the jobs market was very tight, which then became the selling point for higher rates by the Fed.
Things started to turn in the 4th quarter when both inflation and the jobs data started to show signs of easing. A drop in monthly CPI coupled with a rise in the unemployment rate and smaller NFP readings made investors start to shift their expectations about how much further could the Fed hike its funds rate, especially given there had already been 300bps of tightening between March and September, which started to weaken the bullish sentiment that had dominated the USD in 2022.
Despite the data, the Fed went on to hike another 75bps in November, but the messaging from that meeting started to show signs of weakness in the hawkish rhetoric, which gave more fuel to USD bears. As of year-end, the Dollar index has dropped almost 10% since its peak at the end of September. In the last 3 months, the US dollar has lost 8% against the Japanese Yen and the New Zealand dollar, 6.7% against the British pound, and 5.8% against the Euro.
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Q4 2022 performance of the top USD FX pairs (as of December 20th)
Q4 2022 performance of the top USD FX pairs. Photo: capital.com. Source: tradingviewFundamental forecast: inflation vs growth
Fed rate hike path
The December FOMC meeting happened mostly as expected by markets. The Fed slowed the pace of rate hikes to 50bps as the economy shows clear signs of cooling and the full impact of the previous hikes is still to be seen. The reaction in the markets was pretty uneventful and traders quickly moved their attention elsewhere but given the updated dot put and predictions it seems like markets are underestimating the Fed’s ability to keep monetary conditions tight for the foreseeable future.
In a nutshell, Jerome Powell and his colleagues told us that they were more hawkish than people were expecting and that the market-implied rate curve should be adjusted upwards. In response, markets adjusted their expectations downwards, therefore defying the Fed’s projections.
FOMC dot plot comparison September/December 2022. Source: federalreserve.orgThe updated dot plot chart shows that the majority of FOMC members expect the fed funds rate to peak above 5% at some point in 2023, whilst markets are suggesting the peak rate to be 4.9%. What’s most interesting is that the dot plot suggests rates will remain elevated throughout 2023 and that the rate will still be between 4% and 5% in 2024, something that markets are discounting heavily. As of December 19th, markets are pricing in 140bps of cuts by the end of 2024, which would bring the rate down to around 3.1%, a stark contrast to the predictions from the Fed.
Powell referred to the dot plot a few times in his post-meeting press conference which showed that despite his previous remarks at the end of November, the Chairman of the committee is still very much hawkish. But not only did he use the updated chart to prove his point as he was quick to reference the historical lesson that easing too early can be a terrible mistake for the economy, something he already pointed out back in November. He also made reference to the tight labour market and the need to see more data to convince him that price pressures have actually eased before he could start thinking about loosening financial conditions.
This means that if the Fed is to be believed, there is a clear divergence between what may happen and what markets expect to happen, and that creates a good opportunity for traders. The first place to watch this diversion unfold is the bond market, where longer-term rates are currently below shorter ones, meaning the yield curve is inverted, a clear sign of recession expectations. This would support the view that the Fed will not be able to hold rates at current levels for long because the economy is going to start facing trouble soon, and therefore the market-implied rate curve would be correct in predicting lower rates in 2023 and 2024.
US 10-year/2-year yield inversion
US 10-year vs 2-year yield differential. Photo: capital.com. Source: tradingviewBut if we go back to believe the Fed is correct in its predictions, and therefore is not as concerned about economic growth and will hold rates higher for longer, then the yields on longer-term bonds will have to adjust upwards, which is then bullish for the US dollar.
So taking the markets vs Fed rate curve pricing, the divergence between the two is a key fundamental factor to be USD bullish in 2023 if the fed is indeed correct in its predictions.
China reopening
Another key theme to watch out for in the first quarter of 2023 is the Chinese reopening trade. The flight to safety in the US dollar has been running out of steam and the positive sentiment being priced in from the end of zero-covid policies hasn’t been helping. But the growth potential in the first half of the year is limited given the resurgence in covid cases as the reopening takes place, and this will lead to caution in markets. The potential in the second half is much greater, but even still, given the risks in the property market and the slide in productivity, there will likely be some repricing of risks.
For the dollar, a reopening that is successful in limiting the spread of the virus and therefore allows for growth to build throughout the first half year will be a bearish scenario. On the other hand, if we see the government getting cold feet about the removal of restrictions as the number of new cases rises then we could see the dollar picking up some more safe-haven demand and therefore remain supported throughout the first quarter of 2023.
3 possible outcomes
Overall, taking into account growth, inflation and central banks three key scenarios could unfold in 2023.
- Persistent inflation and deep recession - The dollar rally resumes on safe-haven flows
- Moderate inflation and mild recession - The dollar remains supported but the Q4 selloff fails to reverse
- Inflation subsides and growth recovers - The US dollar selloff continues
USD technical analysis
USD/JPY | Will the BoJ finally raise rates?
USD/JPY has been one of the most followed USD pairs in 2022 as it has been a key barometer of market expectations about Fed interest rates. Following the moves in USD, the pair spent most of 2022 heading higher as Powell and his team became more and more hawkish, all whilst the Bank of Japan (BoJ) seemed to be getting more dovish despite consumer prices picking up slightly.
The heavily overbought conditions meant that USD/JPY was one of the best pairs to trade the USD selloff throughout the fourth quarter, with strong daily selloffs as the latest data showed off the cooling in the US economy. The pair is currently trading at its lowest level since August after the strong selloff seen on Monday the 19th on the back of the latest BoJ meeting.
The key takeaway from this meeting is that the bank has widened the band for its yield curve which has led markets to believe this is the beginning of the end of the negative rates era. That said, this doesn’t mean rates have been increased, at least not yet, so the reaction in the market may be overdone. The reality is that markets were expecting a policy change given some recent comments from BoJ members, but it seems more likely that it would come sometime in 2023, most likely after Governor Kuroda’s tenure ends in April, so that is likely where most of the move has come from, as he is perceived as an ultra-dove.
It also feels like the market wasn’t pre-positioned for this move and those who missed out have been chasing the move lower, which has exasperated the move, especially in a week that was expected to be quiet for markets with reduced liquidity in the lead-up to Christmas.
Looking ahead at 2023, the path of least resistance seems lower for USD/JPY, especially if this end of the negative rates era continues to play out. That said, we may be in for some correction over the coming days as rate expectations are rebalanced, meaning USD/JPY could revert to its short-term mean and 200-day SMA around 136.20.
USD/JPY will continue to be a rate differential trade and given the moves this week it looks like the selloff has been slightly overdone, which also supports a short-term rebound. Of course, the latest economic data will continue to be of key importance, especially the US CPI and jobs data, as well as the next Fed meeting on February 1st and the next BoJ meeting on January 18th.
If the fading inflation and moderate growth rhetoric continue to unfold, alongside a more hawkish BoJ and smaller rate hikes from the Fed then we could see USD/JPY head back towards 128 through the first few months of the year.
USD/JPY vs US/Japan 10-year yield differential. Photo: capital.com. Source: tradingviewGBP/USD | Fed vs BoE divergence continues
GBP/USD has staged an impressive 12% recovery since its lows back in September, but that of course happened on the back of a 15% drop over 6 weeks as the political turmoil in the UK unfolded at the end of Q3.
The bearish sentiment has been present throughout most of 2022 as the pair dropped almost 25% from peak to through in the first 9 months of the year. The weakness in the Pound has much to do with the same factors affecting the rally in USD, most notably the raging inflation and the policy divergence between the Fed and the Bank of England (BoE). Added to that, was the political turmoil that sent UK gilts into a frenzy that necessitated intervention from the BoE to calm investors.
Looking ahead to 2023, the key theme for GBP/USD will continue to be the policy divergence between the Fed and the BoE. Whilst both banks hiked 50bps at their December meeting, the messaging from the Fed remained very hawkish (despite markets failing to believe them) whilst the BOE saw two members call for no change, which shows the lack of conviction in the hawkish rhetoric. As mentioned earlier, there is some room for repricing in the market-implied Fed rate curve, and that means that the policy divergence between the Fed and BoE is not yet fully priced in, which would suggest a bearish repricing in GBP/USD.
If the Fed remains hawkish and is able to convince markets that rates will remain elevated for longer whilst the BoE lacks conviction in its fight against inflation then GBP/USD will likely dip below 1.20 and may even pull back 1.17 if it manages to break below its ascending wedge pattern.
On the contrary, if we see the 200-day SMA continuing to provide support around 1.2080 then GBP/USD is likely going to test the upper bound of its resistance range at 1.2665.
Markets will also pay attention to the UK’s large current account deficit. Despite the austerity measures imposed by the new government has helped ease the nerves in the bond market, there is still a risk for GBP as the UK economy continues to battle persistent inflation and the risk of recession, all whilst the government’s debt relative to its economy is one of the worst of the G7. This will make the UK a less attractive market for foreign investment, which could impact the pound. There are also other risk factors like the reopening trade in China and the continuation of the Ukraine-Russia war which will impact the pound as a high-yielding currency and the USD as a safe haven asset.
GBP/USD daily chart. Photo: capital.com. Source: tradingviewRelated topics
