Dollar Strength: Sum of All Fears
Investors typically assess the strength of the U.S. dollar (USD) through a Federal Reserve-centric lens. The dollar’s exceptional strength against a broad basket of currencies has clearly benefited from seven rate hikes last year that took the Fed’s target federal funds rate to its highest level in 15 years. As the Fed continues its fight to bring down inflation in the U.S., we expect it will hike rates again at its next meeting on 1 February, and again in the first quarter of 2023, before pausing.
While higher yields clearly worked in the dollar’s favor last year, any forward-looking view must also take into account how the dollar was buoyed by the shocks of 2022 – the Russia-Ukraine war, the spike in energy prices, and inflation – and the extent to which they may abate in 2023.
PIMCO believes the dollar, which has depreciated since hitting a 20-year peak last September, is likely to fall further in 2023 as inflation falls, recession risks decline, and other shocks abate.
Risk aversion drove USD strength
In addition to higher interest rates and yields in the U.S., the USD gained support from risk-aversion across two vectors.
First, monetary policy has been much more volatile than normal and highly correlated across developed market countries. Since March 2022, policy has tightened sharply almost everywhere (except China, where financial conditions tightened via other channels). Accordingly, volatility rose in markets for fixed income, foreign exchange (FX) and equities. The USD – widely viewed as a safe haven – benefited.
Second, while we have tended to describe USD strength chiefly as a reflection of U.S. economic policies, in our view it is more likely the sum of fears elsewhere – or more specifically, major shocks that hurt growth in key regions. These include:
- A substantial risk premium imposed on European assets last year for the tail risk that Russian energy supplies could be severed – or worse, a nuclear event
- The Russia-Ukraine war amounted to a global shock in terms of trade for energy. Importers in Asia and Europe suffered from higher energy prices while exporters such as the U.S. reaped the gains.
- And then there was Beijing’s zero-COVID policy, which created a negative demand shock for China and the region.
USD weakness ahead
Over the coming months, though, we believe the dollar’s yield advantage versus other developed economies will narrow as the Fed moves toward an expected pause in its hiking cycle in 1Q 2023. Given the faster pace of cumulative rate hikes on the way up, the USD’s yield advantage is likely to fall in the early stages of a rate-cutting cycle, even if the dollar sustains its relatively high yield.
Moreover, changes in risk perceptions about inflation and growth have tended to be inversely correlated. As inflation recedes, growth expectations tend to improve. This tends to reduce uncertainty and works against the broad strength of the USD, in our view.
Other factors that could promote USD weakness include:
- Fed policy, which tends to govern the pace of rate hikes elsewhere. A slowdown – and eventual pause – in the Fed’s rate-hiking cycle likely means other central banks slow and eventually pause.
- A reduction in uncertainty and increase in risk appetite among investors as inflation falls. Even if other central banks retain higher real interest rates, nominal rates are likely to fall globally as inflation declines.
- The end of China’s zero-COVID policy, at least to the extent it leads to a firm recovery
How the dollar’s path may unfold
In short, we believe risk premiums will decline as inflation – and monetary policy volatility decline. New shocks are clearly a risk, but the risk premium in the USD (and cross-asset volatility) remains substantial, in our view.
None of this precludes the possibility that inflation becomes stickier in the U.S. than in other advanced economies or that monetary policy remains tight for an extended period. Indeed, current levels of implied volatility in currency and fixed income markets suggest the risk premium in USD market pricing remains sizable.
However, these premiums could decline further as shocks recede and evidence builds that last year’s surge in inflation is well and truly improving and abating. We expect the USD will continue to lose its appeal as the safe-haven currency of last resort.
Learn more about PIMCO’s near-term outlook for the global economy and markets in our latest Cyclical Outlook, “Strained Markets, Strong Bonds.”
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio.
Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.
PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world. ©2023, PIMCO.