The greenback has shown mixed performances during previous periods of economic and market volatility
by IFAST RESEARCH TEAM
IT HAS been a strong decade of performances for the US dollar. Since 2011, the US Dollar Index (DXY) has surged by a staggering 43%, making it one of the best performers among major currencies over the past decade. Even amid this blistering run, only several years have stood out where the US dollar has reigned supreme — 2022 was certainly one of these years, driven by a combination of widening policy rate differentials as well as safe haven flows.
However, with this dramatic run-up, the US dollar now appears significantly overvalued, and we believe this could set up a reversal for the dollar ahead.
US dollar valuations and positioning look fairly stretched. Following this sharp run-up, we believe the US dollar appears to be overvalued. A look at the real effective exchange rate (REER) — which measures a currency against a weighted average of several foreign currencies adjusted for inflation — shows that valuations are currently more than one standard deviation above their historical average.
For confirmation, we also look at the purchasing power parity (PPP) for the US dollar, which is based on the “law of one price”. PPP essentially compares the purchasing power of various currencies, benchmarked to a pre-specified basket of goods. Currently, PPP suggests that the US dollar is overvalued against every other G10 currency except the Swiss Franc, and its largest overvaluation is a whopping 30% against the Japanese yen.
While the overvalued US dollar sets up for a potential reversal, we think the heav y net long positioning in the US dollar hints that this reversal could come sooner than expected. Across 2022, investors have bet on a stronger greenback by buying the US dollar — as a result, traders are net-long the US dollar — and this long positioning has remained high at almost one standard deviation above historical averages even after the pullback in recent months. With net long positioning already heavily stretched, we think conditions are ripe for a correction as the emergence of more negative catalysts can drive traders to pare back US dollar longs.
We believe a correction in the US dollar will largely be driven by a reversal of the main US dollar drivers seen this year, namely widening policy rate differentials and safe haven flows. Furthermore, we also see catalysts emerging for major constituents of the DXY Index, which could in turn result in a weaker US dollar in 2023.
US Dollar Weakness
Narrowing rate and yield differentials could drive US dollar weakness. One of the main drivers for US dollar strength in 2022 was the widening policy rate and yield differentials. Across the year, the US Fed has hiked rates more aggressively than many of its developed market (DM) central bank counterparts in 2022. The widening of rate differentials has in turn led to widening real yield differentials, putting upwards pressure on the US dollar.
Looking ahead, we expect this US dollar driver to fade and eventually reverse. For the US, we expect the Fed to pause its rate hike cycle in early 2023 at a terminal rate of around 5%, following which they will likely maintain this level of policy rates throughout the year. In contrast, we see room for other
DM central banks to catch up to the Fed in terms of rate hikes, particularly as many other DMs are facing stronger inflationary pressures.
With other DM central banks potentially “out-hiking” the Fed to rein in inflation, we believe that rate differentials are poised to narrow next year, which could drive capital outflows from the US and put downward pressure on the US dollar.
The US dollar has shown mixed performances during previous periods of economic and market volatility. Another key driver for the US dollar in 2022 has been safe haven flows amid a volatile macro and market environment, though we believe that the US dollar’s safe-haven appeal may falter in 2023.
First, safe haven flows could ease if the global economic slowdown turns out to be milder than expected. Markets are already beginning to price in a recession, observed through the stretched US dollar long positioning displayed above, and potential positive factors like the ongoing China reopening could provide some support for global growth in 2023.
Furthermore, even in a more “negative” growth scenario where safe haven demand remains robust, the US dollar may also face stronger competition from safe haven alternatives like the yen and Swiss franc next year, particularly if we see a gradual reversal of rate and yield differentials (highlighted above), as well as growth differentials.
Hence, there are multiple variables at hand, which could affect the extent of broader safe haven demand in 2023, as well as the relative attractiveness of the US dollar over other safe haven currencies. With so many unknowns, it is unsurprising that the US dollar has not consistently demonstrated safe haven properties throughout the years. We first look at US dollar performance stretching back to 1969 and find that (annualised) returns were negative during four of the eight recessions (defined by NBER) in this timeframe.
We then look at US dollar performance in periods of market volatility (gauged by the VIX Index) and find no consistent positive correlation between the US dollar and VIX which one might expect from a safe haven (average correlation of 0.05 since 1991). Furthermore, we found seven instances of high volatility (defined by VIX peaking above 35), and also found that correlations were negative in three of these seven instances.
Perfect storm of factors affecting key DXY currency constituents could ease up in 2023.
Lastly, we also expect major constituents of the DXY (euros, pound, yen together account for over 80% of the DXY Index) to perform better in 2023. In 2022, weaknesses in these currencies were further driven by idiosyncratic factors beyond the US dollar strength and this perfect storm of factors has contributed to the unprecedented US dollar strength. However, the reverse is also true as strengthening these currencies could pave the way for a weaker US dollar.
What Should You Do in An Environment of A Weaker US Dollar?
To conclude, we believe rich valuations and heav y long positions set up a potential US dollar peak and correction in 2023. Potential catalysts include narrowing rate differentials, and an easing of safe haven flows towards the US dollar, while an improvement in other major currencies could also indirectly result in a weaker US dollar (through its currency pairs).
This has implications not only for currency markets but also for many of us investors. Investors should evaluate their portfolios and consider hedging away their US dollar exposure where possible.
- The views expressed are of the research team and do not necessarily reflect the stand of the newspaper’s owners and editorial board.
- This article first appeared in The Malaysian Reserve weekly print edition