It’s time to bet on a falling U.S. dollar because the Federal Reserve looks likely to cut interest rates before year-end while its eurozone counterpart, the ECB, keeps tightening monetary policy, argued strategists at TS Lombard, in a Wednesday note.
“This week we short DXY futures…,” said Skylar Montgomery Koning, senior global macro strategist, and Andrea Ciccone, head of research, at TS Lombard, in a Tuesday note. They were referring to futures contracts on the ICE U.S. Dollar Index
a measure of the dollar against a basket of six major currencies.
The U.S. dollar went on a rampage in 2022, soaring to multi-decade highs versus major counterparts, including the euro
which traded below parity for the first time in over two decades, along with the Japanese yen
and the British pound
The ICE U.S. Dollar Index soared to a 20-year high in October, but has since retreated by around 15% and has retraced more than 50% of the rally from its Jan. 6, 2021, low to its October 2022 high.
The dollar soared last year as the Federal Reserve embarked on a breakneck series of interest rate increases, lifting its benchmark rate from near zero to above 4% with a series of outsize moves in its effort to bring down inflation. The Fed is now seen slowing the pace of rate increases in 2023.
The Fed and market participants have been at odds over the rate path, with policy makers emphasizing their expectations for the fed-funds rate, now at 4.25% to 4.5%, to top out above 5% and remain there for some time. Money markets show participants expect the fed-funds rate to top out below that level and potentially fall before year-end.
TS Lombard said its chief economist, Steve Blitz, expects decelerating inflation will lead the Fed to end the tightening cycle shy of 5%, with a quarter-point rate hike in February possibly its last of the cycle. He sees rate cuts under way by midyear as the market moves to price in a recession, which would put downward pressure on Treasury yields.
While the Fed led central banks in tightening policy in 2022, pushing up U.S. yields relative to global government bond yields and lifting the dollar, that dynamic has flipped this year, the strategists said.
“Moreover, the 2-year differential, which signaled the bullish turn of the dollar in June 2021, has now moved in favor of euro upside for the first time since then,” they wrote (see chart below).
As for the euro/dollar currency pair, the question for investors will shift from will the Fed cut rates in 2023 to “how deep,” the analysts said. The European Central Bank, meanwhile, is likely to stick to an aggressive series of rate increases indicated at its December policy meeting.
“The ECB has an overtightening bias, but also began its tightening cycle later than the rest of [developed-market economies] and so has done less cumulative tightening,” they wrote. “This means that European rates are less restrictive, giving the bank more room at this stage in the cycle to hike and then pause. Rates markets seem to reflect this view: in terms of ECB cuts in 2023, there is little priced in at this stage. Thus, there is likely to be a period in which the story is one of Fed-ECB policy convergence.”
They added a caveat, however.
“There does seem to be a limit on how tight the market thinks the ECB can get: the higher the ECB terminal rate priced in by the market, the more the market prices in cuts,” they said. And since a U.S. recession would make an EU recession worse, the ECB would likely have to follow the Fed in cutting rates at some point.