Is King Dollar’s reign at an end?

A key feature of 2022 was the relentless US dollar bull market, which only started to fade in late 2022.

This was driven by the US Federal Reserve (Fed)’s rapid tightening of policy, rather than interest rate differentials between countries. Central banks elsewhere were also forced into hiking interest rates – albeit hesitantly – because of rising inflation and to stop excessive weakness in their own currencies.

Markets typically do not reward currencies whose central banks are reactive.  

Differential equation

Most central banks now admit they have an inflation problem. Their action to curb rising prices will likely last longer than the tightening cycle in the US. We believe this change in behaviour will restore interest rate differentials as the most important driver of exchange rates – and will act as a headwind to the US dollar in 2023.

We held an outright short US dollar exposure in our portfolios until mid-December, but that has now moderated somewhat. The reason for our caution is that the market now embraces the weaker dollar theme amid the receding energy crisis in Europe and the expectation of a rebound in China.

We don’t disagree with this narrative, but market dynamics like price and investor sentiment also play an important role in our decision-making and we continue to look for opportunities to switch to more pessimistic views on the US dollar.

The not-so-mighty greenback

If the weaker US dollar narrative plays out as markets anticipate, euro and sterling will be beneficiaries.

The UK and Europe are both likely already in recession, but reasonable hard data covering the final quarter of 2022 , alongside both lower energy prices and the easing of the energy crisis, both suggest the near-term path for Europe may not be as bad as feared. The European Central Bank, meanwhile, has turned more hawkish and its hiking cycle could last longer than the Fed’s.

Regarding sterling versus euro, consensus is more pessimistic on the UK’s macro outlook. We wouldn’t disagree, but think sentiment is quite negative on sterling already, which we believe is also reflected in prices. As such we are neutral for now, but may look to buy sterling on any further weakness. 

Emerging blue sky

Since the COVID-19 pandemic, the current account balances of emerging markets have been on a rollercoaster ride.

Having seen larger deficits at the start of last year, more recently we have seen deficits shrinking again. Energy prices have come down from peak levels, while monetary policy tightening is putting the brakes on domestic consumer demand, in turn exerting downward pressure on imports.

We believe the combination of falling global inflation, a weaker US dollar and smaller current account deficits across emerging markets should bode well for emerging assets.

We retain our positive stance on local emerging market debt, but are also removing our negative view (in forex) on some of the large-deficit countries, namely Colombia and the Philippines.