Bottom line
- Following a spectacular year for the USD, in which it appreciated to two-decade highs due to Fed rate hikes, Europe’s energy crisis, the Russia-Ukraine war, and China’s lockdown persistence, the tides appear to be turning against it. Its overvaluation is sitting at an unsustainable 20%, and although this does not mean it will retrace the full extent of that overvaluation, it does suggest that some degree of correction is inevitable.
- The most likely catalyst for a USD correction in 2023 is a Fed pivot to looser monetary policy. The worst of the ongoing inflationary episode is in the rear-view mirror, meaning the case to keep monetary conditions tight for longer is weakening. Accordingly, the market is slowly but surely starting to position for rate cuts and, in turn, USD weakness.
Baseline view
- While the USD might not fall back to its 2021 lows anytime soon, it will likely weaken through 2023. The balance of risks is tilted against it, and a further correction appears to be more a matter of when than if.
The year of the USD bull
2022 has been a remarkable year for the USD. As reflected in the adjacent chart, it rose to its highest since 2002 on the back of the Russia-Ukraine war, Europe’s energy crisis, China’s aggressive Covid-Zero policy, and, perhaps most notably, the US Federal Reserve’s determined rate-hike cycle.
Between these risks, investors around the globe took shelter in the traditional safe haven of the dollar. But the collective risk of these factors arguably peaked earlier in Q4, meaning it is more than likely that another spectacular USD rally is over. So what lies ahead? After all, there are new risks on the horizon, including that of a global recession.
Traditionally, the USD has performed well during economic downturns, meaning it should remain supported well into 2023. However, what makes this episode slightly different from others in history is that the USD is already extremely overvalued going into the expected recession.
Unsustainably overvalued
The latest run of the house valuation model shows the USD to be around 20% overvalued, as illustrated in the chart to the right. For context, this is the largest degree of overvaluation in nearly four decades. Historically, such extreme degrees of overvaluation have not been sustained for very long as they set in motion a range of market responses that ultimately result in a reversal.
This has more to do with the degree of overvaluation, rather than debating whether or not the USD deserves to be overvalued. The USD could comfortably depreciate 10%-15% and remain overvalued. One could maintain the view that the USD should be overvalued and still anticipate a bout of USD depreciation. That is to say that although significant USD-supportive economic risks remain, it is looking increasingly vulnerable.
All eyes on the Fed
The extent of the USD’s correction lower through 2023 will likely be determined by the Fed’s policy decisions. While global recession risk is fundamentally USD-supportive through various channels, the monetary policy response to recession could very well determine the USD’s trajectory going forward.
As illustrated in the adjacent chart, the worst of the US inflation episode is likely in the rear-view mirror, with strong disinflationary forces expected to take hold in the coming months. Between the Fed’s aggressive rate hikes and quantitative tightening, the inflationary cycle has well and truly turned.
The million-dollar question now is, what is the Fed’s economic pain tolerance? Will it remain true to its hawkish signalling and maintain extremely tight monetary policy for an extended period of time, or will it declare victory over inflation and turn more growth-supportive? Judging by the implied market expectations of the Fed funds rate currently reflected by the Fed funds futures market, investors are positioned for the latter.
The foretold pivot
The chart shows that the market expects a pivot towards looser monetary policy around the middle of next year. As economic growth headwinds in the US become stronger and the labour market loosens, the argument for maintaining tight monetary conditions will weaken. In turn, there will be significant pressure on the Fed to turn more growth-supportive by cutting interest rates.
The market is currently positioned for the Fed funds rate to top out around 4.9%, followed by rate cuts through H2 of 2023 and beyond. In a world where the USD is extremely overvalued and so much of that is a function of monetary policy disparity, a sharp reversal in Fed policy would weigh heavily on the USD and help it correct lower. It is thus not surprising that the market is already starting to position for USD weakness.
USD shorts
As of mid-November, the speculative market turned net bearish on the USD for the first time since mid-July 2021. It served as confirmation that the USD had likely reached its cyclical top. And while the USD (as measured by the DXY) has depreciated around 9% from its 2022 peak, it has just about as far to go before reaching 2022’s starting levels. Moreover, and as pointed out above, it remains around 20% overvalued in real terms.
While the USD might not fall back to its 2021 lows anytime soon (unless the Fed is forced into an extreme rate-cut cycle and quantitative easing), it is likely to weaken through 2023. The balance of risks is tilted against it, and a further correction appears to be more a matter of when than if.