The Federal Reserve’s dovish December pivot has raised questions about the future of the weakening dollar. While the case for the dollar’s decline into 2024 seems plausible, the strength of the U.S. economy could limit its downfall. Following the Fed’s rate hikes in 2022, the U.S. currency reached a two-decade high. However, it has been relatively range-bound this year due to robust U.S. growth and the central bank’s commitment to keeping borrowing costs elevated. This has resulted in the dollar heading for a 2% loss against a basket of its peers, marking its first yearly decline since 2020.
During the December Fed meeting, Chairman Jerome Powell announced an unexpected shift in monetary policy. He stated that the historic monetary policy tightening was likely over, thanks to cooling inflation. As a result, policymakers now project 75 basis points of cuts for the next year. The anticipation of falling rates usually acts as a headwind for the dollar, as it makes U.S. currency assets less attractive to yield-seeking investors. While strategists predicted a weaker dollar in the upcoming year, a faster pace of rate cuts could potentially accelerate the currency’s decline.
Despite these projections, some investors remain cautious. Betting on a weaker dollar has been challenging in recent years, and they are wary of jumping the gun. One factor that could present an obstacle for bearish investors is the U.S. economy’s continuous outperformance compared to its peers. The Fed’s aggressive monetary policy tightening and post-pandemic growth policies created a strong dollar rally, fueling the notion of American exceptionalism. However, the reversal of these policies may lead to a reduction in the dollar’s strength.
Considering the Impact on the U.S. Economy
For analysts and investors, correctly assessing the dollar’s trajectory is crucial, given its central role in global finance. A weaker dollar would make U.S. exports more competitive abroad and boost the profits of multinationals by making it cheaper to convert foreign profits into dollars. Approximately a quarter of S&P 500 companies generate more than 50% of their revenues outside the U.S. Therefore, the dollar’s performance is closely monitored.
An early December Reuters poll of 71 FX strategists indicated expectations for the dollar to fall against G10 currencies in 2024, with the majority of the decline occurring in the second half of the year. However, the accuracy of these projections hinges on how the U.S. economy fares compared to its global counterparts and the pace at which central banks adjust their monetary policy.
Thus far, the economic landscape has been uneven across different regions. In the eurozone, December witnessed a deepening downturn in business activity, indicating a potential recession. Nonetheless, the European Central Bank remains committed to fighting inflation, pushing back against rate cut expectations. Consequently, the euro has experienced a gain of over 3% against the dollar this year.
On the other hand, certain Asian economies show signs of strength. Paresh Upadhyaya, director of fixed income and currency strategy at Amundi US, believes the market is overly pessimistic about China and India’s growth prospects. Accelerating growth in these countries could increase their demand for raw materials, benefiting commodity currencies such as the Australian, New Zealand, and Canadian dollars. Reports suggest that China will implement policy adjustments to support its economic recovery in 2024.
Jack McIntyre, a portfolio manager at Brandywine Global in Philadelphia, predicts slower U.S. growth and a pick-up in Chinese growth. As a result, he has been selling the dollar to fund the purchase of Asian currencies. McIntyre argues that the dollar’s bull run is nearing its end.
The dollar’s trajectory may also depend on how much the Fed’s easing measures and falling inflation are already priced into the market. Futures tied to the Fed’s policy rate currently reflect investors’ inclination towards more than 150 basis points in cuts for the next year, double the amount projected by Fed policymakers.
However, the potential for the Fed to hold off on implementing further cuts arises if inflation stalls or does not continue to decline. Matt Weller, Head of Market Research at StoneX, suggests that this scenario could change the case for the Fed’s decision.
The weakening dollar presents both opportunities and challenges for different stakeholders. As the U.S. economy continues to perform strongly, the potential for a prolonged decline in the currency may be limited. The divergent growth and monetary policies of global economies, particularly in Europe and Asia, also contribute to the uncertainty surrounding the dollar’s decline. The market’s response to the Fed’s monetary policy and its impact on inflation will likely shape the dollar’s future trajectory.
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