investment insights

    Is persistent dollar strength over?

    Is persistent dollar strength over?

    Key takeaways

    • There are signs that the persistent dollar strength of 2022 may be over
    • We turn underweight on the US dollar (USD), overweight on the Japanese yen (JPY) and have shifted to a neutral positioning on both the euro (EUR) and Swiss franc (CHF)
    • In emerging markets, we retain a Brazilian real (BRL) overweight and Chinese yuan (CNY) underweight.

    In recent weeks, much has changed in global currency markets, thanks to shifting liquidity trends, falling energy prices, easing inflation, and China’s unexpectedly swift reopening. 


    Why is US dollar strength losing steam?

    Firstly, global growth expectations for 2023 have improved. The pace of China’s reopening has been swift, with restrictions withdrawn in a matter of weeks, rather than months, as was expected. Market participants have thus begun to raise their Chinese growth forecasts (we now forecast Chinese growth of 5% for 2023, up from our prior assumption of 4%), and hence risks to existing global growth forecasts are skewed somewhat higher. This is a reversal from 2022, when weak global growth expectations were supporting the dollar.

    Secondly, trends in energy prices are improving the outlook for major economies, especially those heavily reliant on imported energy, notably Europe and Japan. There is a stronger chance now that re-stocking Europe’s gas supplies for winter 2023 (beginning from the third quarter onwards) could be less problematic than the market had expected even a few weeks ago. At the time of writing, January 2023 is shaping up to be the warmest January since 1950, while energy consumption has been much more efficient. Indeed, certain countries have been able to raise their stockpiles in January, when they would usually be falling. This suggests that continued relief on energy prices could be supportive for both the euro and yen, both of which suffered over 2022 from negative terms of trade shocks. The flipside of this is reduced support for the US dollar.

    Continued relief on energy prices could be supportive for both the euro and yen, both of which suffered over 2022 from negative terms of trade shocks

    Thirdly, the pace of US rate hikes is slowing. We have now had two negative surprises on US inflation, as well as signs that the pace of gains in core services inflation is easing, and wage growth – although still high – is moderating on some measures (like average hourly earnings). This should allow the Federal Reserve (Fed) to shift down another gear in its rate hiking pace. In parallel, both the European Central Bank (ECB) and Bank of Japan (BoJ) turned somewhat more hawkish in December meetings. These changes have had significant implications for our higher-frequency models for the US dollar which we must take into account. This is the first time the indicator signals a bullish EURUSD bias (or bearish dollar stance) since mid-2021.

    In light of the above, we now expect the euro to move higher against the dollar, with a year-end EURUSD target of 1.12. Many of the factors cited above could have their greatest impact in the months ahead, so the move could well be front-loaded.


    The yen – an attractive new haven alternative?

    Meanwhile, the Japanese yen is becoming an attractive safe haven alternative to the dollar. We have lowered our year-end USDJPY assumption to 120, with risks skewed to the downside. Beyond the recent stabilisation in US yields, the yen is also benefitting substantially from Japan’s improving terms of trade and increased expectations for the Bank of Japan to move away from extraordinary monetary stimulus measures (like yield curve control). Investor positioning is still underweight JPY while the scope for further asset repatriation flows by Japanese investors remains. All these factors indicate that the momentum towards a lower USDJPY could remain strong in the months ahead.

    The yen is benefitting from Japan’s improving terms of trade and increased expectations for the Bank of Japan to move away from extraordinary monetary stimulus measures

    Long-term Swiss franc strength, shorter term weakness?

    As for EURCHF, our longer-term thesis remains intact. We believe Switzerland’s strong external balances and intervention by the Swiss National Bank – both to temper inflation but also to reduce the size of its large balance sheet over time – will see EURCHF decline on a 12-month time frame.

    That said, the next move on EURCHF is likely to be higher, towards 1.02 over the first half. This reflects the more positive turn in euro sentiment, and a more hawkish ECB. Furthermore, while the Swiss National Bank showed a strong preference for ensuring EURCHF did not deviate higher over 2022, its tolerance could be somewhat higher now. For one, imported inflation could move lower given the sharp decline in natural gas prices (although these are still at elevated levels). Additionally, the US dollar-Swiss franc exchange rate (USDCHF), also of key importance to imported inflation, is now at the bottom of a 0.90 – 1.00 range, so recent dollar weakness has also helped at the margin.



    Given the recent rapid shifts in currency markets, in January we made several changes to our currency allocation in client portfolios. Firstly, after having taken steps to reduce our dollar overweight exposures in both November and December, we have now shifted to a USD underweight across portfolio profiles, with a neutral euro stance. We have also moved from neutral to overweight on the Japanese yen, while in emerging markets, we retain our overweight in the Brazilian real and our underweight in the Chinese yuan.

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