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Do Recent Central Bank Meetings Alter Our US Dollar Outlook?

Thomas O’Mahony

No, we expect that while the US dollar should decline from its current elevated level over the medium term, there are factors that will continue to provide it with support in the short term. If our expectations are met, later this year or early next year should be an opportune time to consider positioning portfolios to benefit from a weaker dollar.

Three of the major central banks have met already this month. The Federal Reserve raised interest rates by 25 basis points (bps) to a target range of 5.0%–5.25%, and it seems likely that it may pause on any additional rate hikes this cycle. While also hiking by 25 bps, the European Central Bank has “more ground to cover,” with the strength in core inflation indicating one or two further hikes are likely. The market broadly concurs with this assessment and is also pricing in a similar amount of further tightening from the Bank of England after it too raised rates by 25 bps.

The valuation of the dollar is currently very elevated. As of the end of April, its real effective exchange rate stood 28% above its long-term median against our developed markets (DM) trade-weighted basket. As we move through what we anticipate will be a US recession later this year, the subsequent progression into the recovery phase of the cycle should prepare the ground for some of the dollar’s richness to be shed. First, currencies of regions with greater economic cyclicality, such as Europe and emerging markets (EM), stand to benefit most from the reacceleration in economic activity. Second, with central banks likely to eventually cut interest rates to support activity, the scope for greater cuts from the Fed suggests we should ultimately enter a phase where interest rate spreads are less supportive of the dollar. Finally, most of the remaining risk-off premium that has accrued to the greenback, as we have cycled from COVID-19 to the war in Ukraine and (we expect) into a recession, will be given up.

Nonetheless, in the short run, the onset of recession is likely to place a floor under the dollar. The currency has a perfect record in terms of rallying across the last seven US recessions, with a median appreciation of 4.5% from immediately prior to the onset of recession, to its peak. Furthermore, nearly three full cuts are now priced in for the Fed before year end. As inflation is proving slow to decelerate, the market may be disappointed in how slow the Fed is to pivot, resulting in some short-term support from rates differentials. Lastly, net speculative positioning in the dollar is now negative and the currency is in deeply oversold territory. Such negative sentiment can help to propagate a move higher if one of the fundamental catalysts materializes.

There are, of course, risks to this short-term view. For one, it is possible that the greater degree of tightening delivered in the United States, combined with stresses in the domestic banking sector, will result in a steeper domestic recession than transpires globally. Second, with core inflation continuing to accelerate in Japan, risks are rising that the outcome of new Bank of Japan Governor Kazuo Ueda’s policy review will be to abandon its ultra-easy monetary stance. An exit from Yield Curve Control and the possibility of future rate hikes would see a strong appreciation of the yen. Finally, while the potential impact is far from certain, a failure to raise the debt ceiling in the United States could also lead to more immediate dollar weakness.

A lot of ink has been spilled in recent months on the topic of “de-dollarization.” We think this is largely a distraction in determining the outlook for the dollar, as the multi-decade decline in the US share of reserves has been swamped by cyclical factors in determining its direction. What’s more, the extent to which this process is happening in the first place, particularly in the last year or two, is exaggerated by several factors, most notably by ignoring the relative valuation impacts of rising rates on central bank bond portfolios. Only Russia and some satellite states have made a concerted effort to truly de-dollarize, with sanctions the obvious motivation. No material, tangible efforts have been made by other major reserve holders to move off the dollar axis. The absence of any other sufficiently large, deep, liquid, and legally protected securities market—and a country with a current account deficit to provide it—means further de-dollarization will likely continue to be a gradual affair, if it indeed continues.

Given our near-term view, we believe investors should hold off on altering portfolios to account for a potential medium-term weakening of the dollar. However, looking through to the potential early cycle recovery, we see assets that would benefit from the greenback’s depreciation. EM equities tend to outperform developed peers when the dollar softens, particularly during the recovery stage of the business cycle. Current consensus expectations call for a widening of the EM-DM GDP growth differential over the next couple years, and EM valuations are undemanding today. This setup would support performance once economic activity begins to rebound. Furthermore, non-US investors that may have US overweights arising from the dollar run-up, or from underlying investment performance, should consider increasing dollar hedges where the cost is not an excessive headwind.

Thomas O’Mahony
Senior Investment Director, Capital Markets Research