Swift transition to a weaker dollar

Key takeaways

• We see the US dollar weakening going forward, as several factors we were tracking changed course, mainly in December
• These included better news on Chinese growth, receding risks from the natural gas shock on a six- to nine-month view, and a slowdown in the pace of Federal Reserve (Fed) rate tightening
• Our indicators have now shifted to suggest that the dollar’s decline against both the euro (EUR) and the Japanese yen (JPY) could continue, especially over the first half
• We have therefore revised our forecasts, and now target the EURUSD at 1.10 over three months and 1.12 over 12 months. For the USDJPY, we lower our target to 120 over 12 months
• Europe’s terms of trade are improving, and its trade deficit is already beginning to narrow, in a reversal of the situation for much of 2022. The euro should therefore be better supported against a range of other currencies, and we revise our three-month EURCHF view to 1.02
• The outlook for emerging market currencies has improved. While some consolidation is possible, we believe this trend can persist as long as US inflation and labour market data continue to cool
• We expect both sterling and the Chinese yuan to remain laggards and to underperform both the euro and the yen.

We see the dollar weakening going forward, as several factors we were tracking changed course. These included far better news, faster than expected, on Chinese growth, receding risks from the natural gas shock on a six to nine-month view and a slowdown in the pace of Fed tightening. Our indicators have now shifted to suggest that the dollar’s decline against both the EUR and the JPY could continue, especially over the first half. We therefore now target EURUSD at 1.10 over three months (1.02 prior) and 1.12 over 12 months (1.08 prior). For USDJPY, we lower our target to 120 over 12 months (128 prior).

Europe’s terms of trade are improving and its trade deficit is already beginning to narrow, the reverse of the situation seen for much of 2022. There is a stronger chance now that re-stocking Europe’s gas supplies for winter 2023 could be less problematic than the market had expected even a few weeks ago. If current trends persist, European countries may be able to exit the current winter with almost 50% of storage intact (higher than the 32% five year average), placing them in a comfortable position for winter 2023. Meanwhile, eurozone growth sentiment is improving from low levels and higher real European yields are also coexisting with narrowing peripheral bond spreads, which is very much the opposite of the 2022 dynamic. This will have positive implications for key EUR cross pairs, like EURCHF. We are therefore revising our three-month stance and pencil in EURCHF rising towards 1.02, before losing some ground in the second half of the year. 

As well as the dynamics set out above, markets have also begun to price in the Fed easing policy in the second half of the year. Rates have become less volatile, benefitting several higher-yielding EM currencies. While some consolidation is possible, we believe this trend can persist so long as US inflation and labour market data continue to cool in Q1, which should help EM currencies appreciate for the next few months.