Don’t count on the US Dollar next year – it’s time for a reversal

• The USD’s strong performance over the past decade has led to it becoming overvalued, while stretched long USD positioning makes conditions ripe for a correction if more negative catalysts emerge.
• Narrowing rate and real yield differentials could drive USD weakness. The USD has hiked rates aggressively and inflation looks to have peaked. We see room for other DM central banks to “out-hawk” the Fed in 2023.
• The USD’s safe-haven appeal may falter in 2023, either if the incoming recession turns out milder than expected, or if investors turn their attention to other safe-haven currencies. We find that the USD has not consistently performed well during previous periods of heightened economic and market volatility.
• Major constituents of the DXY – EUR, GBP, JPY – are expected to perform better in 2023. Investors have had ample time to digest the idiosyncratic events in Europe (e.g. Russia-Ukraine War and UK’s fiscal drama), while the BOJ’s recent surprise shift in YCC policy may be a precursor to further BOJ tightening in 2023.
• Investors should evaluate the impact of a potential USD weakening on their broader portfolios, and consider hedging away their USD exposure where possible. Investors into funds should consider opting for hedged share classes for products exposed to the USD (e.g. US equity funds), as well as avoiding USD-hedged share classes.

It has been a strong decade of performances for the US Dollar (USD). Since 2011, the US Dollar Index (DXY) has surged by a staggering +43% (Chart 1), making it one of the best performers among major currencies over the past decade. Even amidst this blistering run, only several years have stood out where the USD has reigned supreme – 2022 was certainly one of these years (Chart 2), driven by a combination of widening policy rate differentials as well as safe-haven flows.

However, with this dramatic run-up, the USD now appears significantly overvalued, and we believe this could set up a reversal for the dollar ahead. In this article, we will outline reasons for a peak in the USD, and negative catalysts that could drive a downward correction moving ahead.

Chart 1: USD has seen a spectacular climb of +43% since 2010

Chart 2: Yearly performance in 2022 has stood out amongst previous years

USD valuations and positioning look fairly stretched

Following this sharp run-up, we believe the USD appears to be overvalued. A look at the real effective exchange rate (REER), which measures a currency against a weighted average of several foreign currencies adjusted for inflation, shows that valuations are currently more than one standard deviation above its historical average (Chart 3). This level has only been reached twice in recent history - (i) before 1972 when the USD was still on the gold standard; and (ii) during the 1980s when the Fed hiked rates to record high levels (20%) - and the current economic backdrop is far from reaching such extremes.

For confirmation, we also look at the purchasing power parity (PPP) for the USD, which is based on the “law of one price”. PPP essentially compares the purchasing power of various currencies, benchmarked to a pre-specified basket of goods. Currently, PPP suggests that the USD is overvalued against every other G10 currency except the CHF, and its largest overvaluation is a whopping 30% against the JPY (Chart 4).

While the overvalued USD sets up for a potential reversal, we think the heavy net long positioning in the USD hints that this reversal could come sooner than expected. Across 2022, investors have bet on a stronger greenback by buying the USD - as a result, traders are net-long the USD, and this long positioning has remained high at almost one standard deviation above historical averages even after the pullback in recent months (Chart 5). With net long positioning already heavily stretched, we think conditions are ripe for a correction as the emergence of more negative catalysts can drive traders to pare back USD longs.

We believe a correction in the USD will largely be driven by a reversal of the main USD drivers seen this year, namely widening policy rate differentials and safe-haven flows. Furthermore, we also see catalysts emerging for major constituents of the DXY Index, which could in turn result in a weaker USD in 2023.

Chart 3: USD’s REER suggests that valuations currently look stretched

Chart 4: PPP indicates that the USD is overvalued against almost every G10 FX (except CHF)

Chart 5: USD positioning remains fairly stretched (net-long)

Narrowing rate and yield differentials could drive USD weakness

One of the main drivers for USD strength in 2022 was the widening policy rate and yield differentials. Across the year, the Fed has hiked rates more aggressively than many of its developed market (DM) central bank counterparts in 2022. The widening of rate differentials has in turn led to widening real yield differentials, putting upwards pressure on the USD (Chart 6).

Looking ahead, we expect this USD driver to fade and eventually reverse. For the US, we expect the Fed to pause its rate hike cycle in early 2023 at a terminal rate of around 5%, following which they will likely maintain this level of policy rates throughout the year. In contrast, we see room for other DM central banks to catch up to the Fed in terms of rate hikes, particularly as many other DMs are facing stronger inflationary pressures (Chart 7). With other DM central banks potentially “out-hiking” the Fed to rein in inflation, we believe that rate differentials are poised to narrow next year, which could drive capital outflows from the US and put downward pressure on the USD.

Chart 6: USD appreciation was accompanied by rising rate and real yield differentials

Chart 7: Many developed markets are facing stronger inflation headwinds than the US

USD has shown mixed performances during previous periods of economic and market volatility

Another key driver for the USD in 2022 has been safe-haven flows amidst a volatile macro and market environment, though we believe that the USD’s safe-haven appeal may falter in 2023.

First, safe-haven flows could ease if the global economic slowdown turns out to be milder than expected. Markets are already beginning to price in a recession, observed through the stretched USD long positioning displayed above, and potential positive factors like the ongoing China reopening could provide some support for global growth in 2023. Furthermore, even in a more “negative” growth scenario where safe-haven demand remains robust, the USD may also face stronger competition from safe-haven alternatives like the JPY and CHF next year, particularly if we see a gradual reversal of rate and yield differentials (highlighted above), as well as growth differentials.

Hence, there are multiple variables at hand, which could affect the extent of broader safe-haven demand in 2023, as well as the relative attractiveness of the USD over other safe-haven currencies. With so many unknowns, it is unsurprising that the USD has not consistently demonstrated safe-haven properties throughout the years. We first look at USD performance stretching back to 1969 and find that (annualised) returns were negative during 4 of the 8 recessions (defined by NBER) in this timeframe (Chart 8).

We then look at USD performance in periods of market volatility (gauged by the VIX Index) and find no consistent positive correlation between the USD and VIX which one might expect from a safe-haven (average correlation of +0.05 since 1991). Furthermore, we found 7 instances of high volatility (defined by VIX peaking above 35), and also found that correlations were negative in 3 of these 7 instances (Chart 9).

Chart 8: USD has not consistently demonstrated resilient performances during recessions

Chart 9: Inconsistent relationship between USD strength and market volatility

Perfect storm of factors affecting key DXY currency constituents could ease up in 2023

Lastly, we also expect major constituents of the DXY (EUR, GBP, JPY together account for over 80% of the DXY Index) to perform better in 2023. In 2022, weaknesses in these currencies were further driven by idiosyncratic factors beyond the USD strength and this perfect storm of factors has contributed to the unprecedented USD strength. However, the reverse is also true as strengthening of these currencies could pave the way for a weaker USD.

EUR and GBP: Narrowing of rate differentials could drive strength against the USD

EUR weakness in 2022 was fuelled by the ongoing Russia-Ukraine War, which has not only dampened risk sentiment within Europe but also resulted in an energy crisis across the continent. While Europe will likely continue to struggle due to slowing growth and elevated inflation levels, a warmer-than-expected winter (as reports are suggesting) could mitigate the effects of its energy crunch in the near term.

Meanwhile, the UK is facing a similar energy crunch, though there was one additional factor of the political drama in mid-2022, particularly with Liz Truss’s disastrous fiscal spending plan that threw Gilts markets into turmoil. Moving into 2023, while the energy crunch could persist over the long term (just like in Europe), we believe that these political and fiscal concerns have already eased significantly with the election of PM Sunak.

As such, we believe that some of the idiosyncratic factors influencing EUR and GBP weakness may weaken slightly as we head into 2023. Coupled with a narrowing of rate differentials as the ECB and BOE attempt to rein in inflation and catch up with Fed rate hikes, we think that the USD is likely headed for a weaker performance against these two currencies in 2023.

JPY: Surprise shift in YCC policy could herald a year of USD weakness against JPY

JPY was one of the worst-performing currencies in 2022, mainly due to real yield differentials – US real yields have climbed up significantly throughout the year while Japanese real yields have remained relatively flat (Chart 10). This has been because BOJ has bucked the global trend of rising rates by maintaining its ultra-loose monetary policy, juxtaposed with the Fed turning much more hawkish throughout 2022.

Looking ahead, we first see the possibility of a slowdown in hawkish rhetoric from the Fed (highlighted in previous sections), which could lead to some stabilisation of the JPY. More importantly, the BOJ’s recent widening of its YCC band has been an unprecedented move and could be a precursor to narrowing rate differentials in 2023. The recent BOJ move indicates that they are warming up to a further tightening in 2023, which should help to push up Japanese yields and ultimately drive the JPY up from its current undervalued levels. Hence, we expect further JPY appreciation relative to the USD as we move through 2023.

Related article: What’s next for Japanese equities after the BOJ shocker

Chart 10: JGB yields have remained relatively flat, while UST yields have shot up

What should you do in an environment of a weaker USD?

To conclude, we believe rich valuations and heavy long positions set up a potential USD peak and correction in 2023. Potential catalysts include narrowing rate differentials, and an easing of safe-haven flows towards the USD, while an improvement in other major currencies could also indirectly result in a weaker USD (through its currency pairs).

This has implications not only for currency markets but also for many of us investors. Investors should evaluate their portfolios and consider hedging away their USD exposure where possible. One consideration for investors into Unit Trusts is the currency class of each fund, which can have a significant effect on fund performance. For instance, looking at the JPMorgan Funds – Japan Equity A (acc) fund, the USD-hedged share class has already outperformed its SGD-unhedged share class by over 12 percentage points purely in 2022 (as of 23 Dec). Hence, given our broadly negative view on the USD, we believe investors should consider opting for hedged share classes (other than the USD) for USD-exposed products (e.g. a US equity fund), as well as avoiding USD-hedged share classes.

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Top Fixed Income Funds of 3Q22: While bonds enter bear market, some funds fared better than others

Declaration:
For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a NIL position in the abovementioned securities.