The dollar’s decline has been widespread, with the Japanese yen, euro, and pound all reaching their strongest positions against the U.S. currency in five months. The driving force behind this trend is the expectation that the Federal Reserve will aggressively cut interest rates in 2024, thus avoiding a recession. As a result, the dollar index, which measures the U.S. currency against six rivals, dropped to a fresh five-month low of 100.61. This represents a significant decline of 2.7% for the year, marking the end of two years of strong gains.
Out of all the currencies affected by the weakening dollar, the Japanese yen was the most responsive. The dollar fell by as much as 0.82% to 140.66 yen, the lowest it has been since July. The yen’s sensitivity to U.S. rates is well-known, and the yield on the 10-year U.S. Treasury dropping nearly 10 basis points on Wednesday only exacerbated the situation. Although the year has seen the dollar appreciate by over 7% against the yen, the recent decline has raised concerns.
Despite his statement, Bank of Japan Governor Kazuo Ueda has generated some optimism with his remarks about no immediate plans to unwind ultra-loose monetary policy. However, the risk of inflation exceeding 2% and accelerating remains small. Currently, there is an 88% chance that the U.S. will cut rates in March 2024, as predicted by the CME FedWatch tool. Moreover, futures indicate over 150 basis points of Federal Reserve easing next year, although the path toward that goal may not be smooth. Market expectations seem ambitious, as they anticipate more than six full rate cuts from the Fed without a U.S. recession. Nevertheless, the process of reaching these targets may encounter obstacles and raise uncertainties not currently priced into the market. Consequently, the dollar’s fortunes could easily reverse when trading resumes in January.
While the Federal Reserve adopted an unexpectedly dovish stance in its December meeting, hinting at potential rate cuts in 2024, other major central banks, such as the European Central Bank (ECB), have maintained their position of needing to keep rates higher for a longer duration. Despite this, markets are projecting as many as 165 basis points of rate cuts by the ECB next year. As a result, the euro rose by 0.15% to $1.121, reaching its highest level in five months. It is also poised to record a strong performance, with a 3.7% gain for the year, its best since 2020. Similarly, the pound climbed to $1.2825, its highest level since August, and is anticipated to achieve a nearly 6% gain, its most substantial since 2017. In addition, the Swiss franc strengthened to 0.8339 per dollar, its highest point since January 2015, when the Swiss National Bank discontinued its minimum exchange rate policy against the euro.
The depreciation of the dollar has had a positive ripple effect on emerging market currencies. MSCI’s emerging market currency index skyrocketed to a 20-month high and is poised to record its most significant annual gain since 2017, with a gain of 5%.
The weakening of the dollar has sparked market optimism, as traders foresee substantial rate cuts by the Federal Reserve without the onset of a U.S. recession. This has resulted in a decline in the dollar index, a surge in other major currencies, and a positive impact on emerging market currencies. However, it remains to be seen whether these expectations will come to fruition or if the market may encounter unforeseen hurdles along the way. Only time will tell if the dollar will reclaim its strength or if its decline will persist in the coming year.
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