G10 FX Weekly: What’s Next for the Dollar?

Summary

• DXY has declined ~3.5% over the past six weeks or so, partly due to more dovish pricing of expectations for Fed monetary policy.
• Broader fears of a US-led recession have also prompted investors to question the basis of USD strength over the past two to three years.

Market Implications

• We expect the recent ranges in the DXY and major USD pairs to hold in the coming weeks. Yet we expect more downside in the dollar after the Fed, ECB and BoE rate decisions next month.
• EUR/USD: the downside (~1.05) of the recent range has been tested and held. The pair now trades back near the top of the 2023 price corridor. In the medium-to-longer term, expect further upside.
• USD/JPY: ~127/138 has contained trade in 2023, and this range will continue in the coming months.
• GBP/USD: the pound briefly fell below and rose above the earlier 2023 range of ~1.19-1.25, and now hovers near the top of the range. We remain bearish sterling longer term, preferring to fade any GBP strength.
• USD/CAD: the 2023 range has been ~1.3250-1.3860, and the pair currently trades just below the mid-point. Expect sideways trade in the pair in the coming months.

Introduction

Since the end of February, the US dollar index (DXY; see Appendix) has quietly and steadily declined by about 3.5%. While rates markets have reacted decisively in repricing Fed expectations, USD has reacted more mutedly.

Nevertheless, the decline in the USD has been notable. Key drivers ahead are the more dovish Fed prognosis and generalised concern over the US economy.

Ahead of the Federal Reserve (Fed) and European Central Bank (ECB) rate decisions on 3 and 4 May respectively, followed by the Bank of England (BoE) a week later, we do not expect a material breakout in the recent ranges for the USD.

In the months following these meetings, however, we expect more downside for the DXY. This probably means a break of the psychological, round number 100 level, which probably then sees the index return to levels not seen since the beginning of the war in the Ukraine (around 95).

Beyond the DXY, we revisit EUR/USD, USD/JPY, GBP/USD and USD/CAD in this piece.

Recent Price Action in the DXY

Since the beginning of 2022, the DXY has traded roughly in a 94.5-115 range, currently trading at ~101.5.

The index started to gain upside momentum in February 2022, when the war in the Ukraine began. The DXY’s most recent peak was in September last year, when concern about the war’s impact on Europe was at is highest, and EUR/USD was at its weakest levels.

Since then, the DXY has fallen about 11.5% from the September high, and now sits about 0.7% above the intraday year-to-date (YTD) low on 2 February.

Near-Term Prognosis for the DXY

In the coming weeks, ahead of the Fed and ECB policy announcements on 3 May and 4 May, expect the YTD range (~100.8-105.9) in the DXY to contain price action.

Both central banks will probably raise rates at these upcoming meetings. Markets price a ~71% probability of a 25bp hike from the Fed; they fully price a 25bp hike from the ECB.

Unless there are major data surprises and/or unforeseen geopolitical or major economic developments (such as further turbulence in the banking sector), expect the DXY to track sideways in the coming weeks.

Longer-Term Prognosis for the DXY

Following these central bank meetings early next month, we expect the dollar to continue to grind lower.

This is partly due to market expectations for monetary policy after the Fed and ECB meetings in May.

Market pricing currently expects the Fed’s hiking cycle to end next month, with a quick turnaround in monetary policy beginning in the late summer or early autumn.

By year-end, the Fed Effective rate is expected to be near 4.35%, or roughly 65bp below the expected peak of ~5%.

Contrast this with expectations for the ECB. The euro-area policy rate is expected to peak near 3.6%, roughly 70bp above the current level. The ECB is not currently expected to begin cutting rates until next year.

Should these interest rate policy dynamics play out, expect the DXY to trade down through 100, putting back into play the ~95 level seen before the war in the Ukraine began.

A(nother) Look at Four USD Pairs

We now revisit the four biggest constituent currency pairs in the DXY: EUR/USD, USD/JPY, GBP/USD and USD/CAD.

EUR/USD

We first looked at EUR/USD in a piece on 23 February, and our current prognosis for the currency pair is similar.

Broadly speaking, we are constructive on EUR/USD. We think that later this year the pair can trade back to levels nearer 1.13-1.15 (i.e., the levels seen before the outbreak of the war in the Ukraine).

Back in February, our short-term view was that EUR/USD would remain stuck in the ~1.05-1.10 range that had prevailed in the first six weeks of 2023.

As outlined above, we think this will continue for another few weeks into the key Fed and ECB meetings. Beyond that, however, for the reasons we outlined in our previous piece, we think there is further upside for EUR/USD.

If the market is right about the respective rate paths for the Fed and ECB, interest rate differentials will move in favour of EUR/USD.

Moreover, improving economic fundamentals, most notably the euro area’s reduced dependence on Russia for energy, will also support EUR/USD. After all, it was geopolitical angst (and attendant concerns about the euro-area economy) that weighed on the EUR last year.

USD/JPY

USD/JPY is trading slightly above the middle of the ~127/138 range seen YTD, having fallen sharply when the SVB/CS news hit the wires.

The Bank of Japan (BoJ) got a new governor, Kazuo Ueda, on 10 April. On Monday, Ueda confirmed that the current loose BoJ monetary policy stance is still appropriate, meaning that the current policy mix of yield curve control and negative interest rates will remain in place for now.

Although BoJ policy is not etched in stone, and a less dovish stance is possible later this year, the Japanese authorities look unlikely to begin tightening policy in earnest when the Fed is at or very near the end of its hiking cycle.

For USD/JPY, this probably means sideways trade within the established YTD range.

GBP/USD

We first looked at GBP/USD (known as ‘cable’) on 16 February as part of a broader bearish GBP piece.

Our near-term assessment for sterling was that it would remain rangebound – this has proven largely true.

Cable, with a short period of brief false breaks above and below, has broadly held the ~1.19-1.25 range we outlined in February. And EUR/GBP has thrashed around within an ~0.8720-0.8930 range since then.

The rise in cable, therefore, has been mostly driven by USD weakness and, for the foreseeable future, this will probably continue.

As with the Fed and ECB, the BoE is expected to raise rates by 25bp next month (the market prices an 80% probability).

Further out the calendar, we remain cautious on sterling, preferring to fade strength (probably best expressed in GBP pairs other than cable).

Inflation remains problematic for the UK economy. Year-on-year CPI remains above 10% in the UK, roughly double that in the US and higher than the euro area’s 8.5%.

Our bearish GBP view was largely based on economic underperformance in the UK. With inflation so high, this threatens to prolong the cost-of-living challenges in Britain and, as such, it will drag on the economy.

Additionally, even though the International Monetary Fund (IMF) was less gloomy this week about the UK’s economic prospects for 2023, it still expects the British economy to lag all other developed market economies this year.  

The pound may continue to participate in the trend of a weaker dollar, dragging cable higher. Nonetheless, we think a long EUR/USD position will be a better way of playing USD weakness than via GBP/USD.

USD/CAD

Traders have already priced the end of the Bank of Canada (BoC) hiking cycle and expect the next BoC move to be a rate cut (probably in October).

The BoC left rates unchanged yesterday and pushed back against rate cut bets currently embedded in market pricing. Despite this, the market still prices the BoC policy rate to be roughly 30bp lower by the end of the year.

With the end of the BoC hiking cycle having probably already occurred, massive further upside for the Canadian dollar against the greenback will likely be limited.

However, dovish Fed expectations for the second half of this year probably caps material USD upside as well.

This means that USD/CAD will likely thrash around in the already established YTD range, with little strong impetus either way to drive a meaningful breakout.

Conclusion

The next few weeks will probably see sideways price action for the DXY and the underlying currency pairs which constitute the benchmark dollar index. Central banks will probably deliver on market expectations in the coming weeks, keeping these pairs within recent ranges.

Later this year, however, expect the DXY to plumb further downside, largely driven by upside in EUR/USD. We expect USD/JPY and USD/CAD to continue to trade within their current YTD ranges and are less convinced that GBP/USD will rise as aggressively as EUR/USD.

Appendix: What Is the DXY?

The DXY is a futures contract that trades on the ICE Exchange. It is widely recognised as the benchmark index for the USD. Futures trading in the DXY began in 1985, with options on those futures being introduced in 1986.

The index measures the value of the USD against a basket of currencies of the top six trading partners of the United States as measured in 1973: the euro area, Japan, the United Kingdom, Canada, Sweden, and Switzerland.

The composition of the DXY is as follows: euro (57.6%), Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%), and the Swiss franc (3.6%).

The US Federal Reserve developed the dollar index in 1973 to provide an external bilateral trade-weighted average value of the US dollar as it freely floated against global currencies. The weights in the DXY have been held constant since inception.

The weights in the Fed’s trade-weighted dollar index (TWI) have changed since 1973 but, irrespective of changes in the weighting and composition of the Fed’s TWI, the current ICE futures contract and cash index matches the Fed’s index very closely.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)