Massive moves in the FX market have been a major focus for investors of late. The Dollar Index (commonly referred to as the DXY index) has shed over 10% since its highs in late September, following a historic +27% rally in the last year and a half. As we mentioned in our 2023 Outlook, we expect dollar weakness to be one of the key themes of macro trades this year. So why is this the case? And how may investors play the theme now?
To understand why weakness in the U.S. dollar could be a sustained trend, it’s helpful to look at what happened in 2022. During 1H, the Fed started hiking aggressively – at a pace that hadn’t been seen in the past 40 years – in the face of a large inflation overshoot. USD rates shot up much quicker than other major currencies. A wider interest rate differential in favor of the U.S. drove a rally in the dollar. In 2H, other central banks started to catch up in terms of hiking rates, but the global growth environment was incredibly weak. In particular, China was going through rolling lockdowns. Europe was facing a potentially very deep energy crisis. Global equity market declines had also deepened. This drove another leg of dollar strength as investors sought a safe haven. The confluence of factors drove the dollar to highly overvalued levels – as much as 20% higher than its modeled fair value (based on 5-year interest rate differentials) at the peak.
What we’ve been seeing the last few months – and what we expect to continue into 2023 – is the erosion of all these pillars that pushed the dollar stronger in 2022. Interest rate expectations are peaking in the U.S. but still rising in the rest of the developed world. In other words, rate differentials have started to turn from a support for the dollar to a headwind. Looking ahead, USD rates will likely continue to “catch down” to other developed markets as U.S. inflation trends lower and the Fed reaches the end of its hiking cycle. Meanwhile, with inflation staying sticky in Europe and picking up in Japan, policy directions of these central banks are more likely to tilt towards the hawkish side. From an asset allocation standpoint, with the disappearance of negative yielding debt in Europe and Japan – and U.S. equities perhaps no longer outperforming global indices – we could start to see a rebalancing of U.S. asset overweights in global portfolios.
Global growth dynamics, the second pillar of dollar strength in 2022, are also shifting. The reopening in China has been faster than expected. In Europe, this winter has turned out to be less cold than had been feared, and natural gas prices have fallen 70% from the peak. Increasingly, the U.S. is looking less exceptional from a growth perspective.
Add in the fact that the U.S. dollar still screens 10% overvalued, and we see some further weakness ahead.
How to trade USD weakness?
Positioning for a weaker dollar generally happens in two stages: First, currencies and precious metals that tend to provide lower growth and yield (like the Euro, Japanese yen, Swiss franc, and gold, aka the “low yielders”) tend to strengthen. And later, when the global economy demonstrates full-on early cycle dynamics, higher-growth-oriented currencies (like commodity FX and emerging markets, aka the “high beta”) will likely join the rally in a more sustained way. We are currently in the first stage. Here are a few ways that we favor participating in this trade:
1. The Euro
The Euro recently rebounded from sub-parity against the dollar to levels seen before the Ukraine crisis. The worst fears for the winter period have not played out, and we have seen large declines in natural gas prices. We still see upside in the Euro from here in the near term. The market is pricing the European Central Bank to hike rates above 3.25% this year. This shift in interest rate differentials is consistent with fair value for EURUSD above 1.15. However, we’d note that energy prices will need to remain benign for us to really see the shift towards fair value. Otherwise, some Europe-specific risk premium will likely stay.
2. The Japanese yen
Moves in USDJPY are closely correlated with interest rate differentials. Over the past two years, changes in the spread between 10-year U.S. treasury yields and 10-year JGB yields explain 80-90% of the moves in USDJPY. Over the recent months, traders started to bet on higher JPY rates (as shown by the spikes in the swap rate), especially after the surprise announcement by the BOJ to widen the yield curve control (YCC) band in late December. While the BOJ meeting in January underwhelmed the market by leaving all monetary policy settings unchanged, the longer-term trajectory is still highly JPY supportive, in our view. The currency remains undervalued especially given that rate differentials look poised to continue to narrow. Core inflation in Japan recently rose to almost two times the BOJ target, and with wage inflation rising, the composition of inflation pressure has shifted from mostly imported to more home-grown, which is a sign of stickier inflation from here. Eventually the central bank would have to think about further normalization in monetary policies.
While the functionality of gold as an inflation hedge is being increasingly questioned, the yellow metal could shine again this year. Historically, gold prices usually gain support from a weaker dollar and lower real yields. With yields peaking in the U.S., the trough in gold could be behind us, with the metal joining the rally of the low yielders. We favor gold not only as a way to participate in the weaker dollar trend, but also from a portfolio diversification standpoint.
Does RMB fit in this trade?
The RMB is getting strong support from improved sentiment thanks to the rapid reopening in China and continued inflows as global portfolios close their large underweights in Chinese assets. Coupled with broad weakness in the dollar, USDCNH declined from a high of above 7.3 to 6.7 levels. However, long CNH is still not how we would express the China re-opening theme (we would rather focus on equities and credits, as discussed in a recent article). Negative carry and risks of further deterioration in the balance of payments as we move through the year suggest that not all CNH-negative factors are neutralized. As the slowdown in goods demand from U.S. and European consumers continues, China’s exports will likely deteriorate from high teens growth over the past two years to a significant contraction this year. At the same time, outflows could see a boost if outbound tourism resumes. Given these factors and how fast CNH has moved, we don’t favor it as a way to trade dollar weakness from here. For dollar-based investors looking to add exposure to CNY-denominated assets, one strategy would be to hedge out FX risks and lock in a positive carry.
All market and economic data as of February 10, 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.
There can be no assurance that any or all of these professionals will remain with the firm or that past performance or success of any such professional serves as an indicator of the portfolio’s success.
We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.
This document may also have been made available in a different language, at the recipient’s request, and for convenience only. Notwithstanding the provision of a convenience copy, the recipient re-confirms that he/she/they are fully conversant and has full comprehension of the English language. In the event of any inconsistency between such English language original and the translation, including without limitation in relation to the construction, meaning or interpretation thereof, the English language original shall prevail.
This information is provided for informational purposes only. We believe the information contained in this video to be reliable; however we do not represent or warrant its accuracy, reliability or completeness, or accept any liability for any loss or damage arising out of the use of any information in this video. The views expressed herein are those of the speakers and may differ from those of other J.P. Morgan employees, and are subject to change without notice. Nothing in this video is intended to constitute a representation that any product or strategy is suitable for you. Nothing in this document shall be regarded as an offer, solicitation, recommendation or advice (whether financial, accounting, legal, tax or other) given by J.P. Morgan and/or its officers or employees to you. You should consult your independent professional advisors concerning accounting, legal or tax matters. Contact your J.P. Morgan team for additional information and guidance concerning your personal investment goals.
Indices are not investment products and may not be considered for investment.
For illustrative purposes only. This does not reflect the performance of any specific investment scenario and does not take into account various other factors which may impact actual performance.
Past performance is not a guarantee of future results.
Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.
Holders of foreign securities can be subject to foreign exchange risk, exchange-rate risk and currency risk, as exchange rates fluctuate between an investment’s foreign currency and the investment holder’s domestic currency. Conversely, it is possible to benefit from favorable foreign exchange fluctuations.
- Past performance is not indicative of future results. You may not invest directly in an index.
- The prices and rates of return are indicative as they may vary over time based on market conditions.
- Additional risk considerations exist for all strategies.
- The information provided herein is not intended as a recommendation of or an offer or solicitation to purchase or sell any investment product or service.
- Opinions expressed herein may differ from the opinions expressed by other areas of J.P. Morgan. This material should not be regarded as investment research or a J.P. Morgan investment research report.
The U.S. Dollar Index (DXY) is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies.