US dollar supported by aggressive Fed action and war in Europe…

After its initial complacency, the Federal Reserve (Fed) was quicker than many other major central banks to combat the surge in inflation. 2022 marked one of the US central bank’s most aggressive rate hiking cycles on record. Other central banks adopted a far less energetic approach. The European Central Bank (ECB), for example, only started raising rates in July – some four months after the Fed – while the Bank of Japan (BOJ) has continued to hold rates below zero. These factors, plus a desire to hold assets perceived as safe havens, propelled the US dollar to multi-decade highs in the second half of 2022.

…but that support is now fading…

However, the props supporting US dollar strength are starting to crumble. The interest rate differential between the US and the rest of the world will likely narrow in the coming months. Headline US inflation has dropped significantly since last summer, falling to 6.4% in January 2023 from a peak of 9.1% in June 2022. As a result, the Fed has dialled back the pace at which it raises rates and is likely nearing its terminal rate. In contrast, the ECB remains hawkish, forecasting further sizeable rate hikes, while a change in BOJ governor may well see the end of negative borrowing costs in Japan.

Diverging economic growth rates between the US and economies elsewhere are also favouring the relative strength of non US currencies. The US yield curve (the difference between two- and 10-year US Treasury bond yields) is currently the most inverted since the 1980s. Such an occurrence, which suggests that interest rates are set to fall sharply in the future, has historically been a strong predictor of a US recession. Meanwhile, in Europe, recessionary fears are easing as natural gas prices fall and the continent makes progress in finding alternative energy suppliers, mitigating its dependence on Russian energy. Elsewhere, China’s surprise zero-Covid pivot should be supportive for the global economy, particularly for Asia and for emerging market commodity exporters.

…allowing other assets to shine

As a backdrop, many commodities are priced in dollars and so US currency weakness could place further downward pressure on inflation, which is already expected to fall due to the high base effects in 2022. Emerging economies are likely to be a beneficiary, as a weaker dollar reduces the debt burden of countries that rely heavily on hard currency bonds to fund their borrowing requirements. Additionally, many emerging markets are well placed to benefit from China’s economic reopening, boosting the outlook for their currencies. Finally, while a weaker dollar may weigh on the returns generated by US companies, it will likely benefit margins for US businesses with significant overseas earnings.