investment insights
A bumpy path to US dollar weakening
Key takeaways
- We believe recent dollar strength could prove short-lived, as US growth slows and hopes of interest rate cuts in 2023 fade
- Falling energy prices could reduce the US’s terms of trade advantage and benefit current accounts in Japan and the eurozone, while tighter credit conditions could drive demand for haven currencies
- We expect the US dollar to weaken against the euro, Japanese yen and Swiss franc in the latter half of the year, and maintain our current dollar underweight in portfolios
- Reducing dollar dependence would require a major shift in international trade patterns. Recent FX reserve diversification away from the US dollar is unlikely to see it lose its dominant status anytime soon, nor drive markets.
As an unexpectedly resilient US economy keeps kicking expectations of a recession into the future, the dollar has been supported in recent months. However, we think that before the end of 2023 it will weaken against major currencies including the euro, Japanese yen and Swiss franc.
The dollar has held its ground in 2023 to date, even amid ongoing turmoil in America’s regional banking sector and a political crisis over the US debt ceiling. One reason is the strength of the US consumer. Buoyed by residual savings and a still-tight labour market, consumer spending has surprised investors. With inflation still above-target and no evidence of a dramatic deceleration in activity, the Fed now looks determined to hold firm on rates until it can claim to have won the fight against inflation, keeping the dollar supported. Conversely, there are signs of cracks in China’s nascent economic recovery, leading to broader concerns over the strength of global growth. Historically, the dollar has remained strong when it offered high yields and the global trade outlook was anaemic. By contrast, the prerequisites for dollar weakness were, typically, much lower US interest rates and a healthy global growth backdrop.
Yet we believe the dollar’s recent strength could be short-lived. With natural gas prices having fallen, the US’ prior trade advantage over energy importers such as Japan and the eurozone has diminished, supporting the euro and the Japanese yen, both of which bore the brunt of the energy shock in 2022. While the Fed is on pause, we expect central banks in the eurozone and Switzerland to tighten monetary policy further, diminishing the dollar’s advantages.
Tighter credit conditions worldwide and investors’ worries about the timing of an eventual US recession look set to benefit other haven currencies in the months ahead. We favour the yen – which traditionally performs well as investor risk aversion rises – and the Swiss franc given its healthy external balances and the Swiss National Bank`s preference for a strong and stable currency to keep imported inflation in check. Meanwhile the bipartisan debt ceiling deal could cap some federal spending until 2024, reducing medium-term demand for the dollar.
However, the path towards a lower dollar is likely to be bumpy as markets re-adjust their assumptions on US monetary policy and global growth prospects. We also expect dollar dynamics to differ depending on the currency pair. For the rest of 2023, we see the US dollar weakening against the euro, Japanese yen and Swiss franc, while strengthening against sterling, the Canadian dollar and Chinese yuan. We expect the euro-dollar to trade in a 1.06 – 1.10 range in the months ahead and to reach a level of 1.12 a year from now.
We maintain underweight exposures to the US dollar and Chinese yuan in client portfolios, with an overweight exposure to the Japanese yen.
The drive to de-dollarise
Longer-term, questions continue to be raised over the dollar’s dominance as a global reserve currency. Indeed, since Russia’s invasion of Ukraine in February 2022, debate around the world’s reliance on the dollar, and its declining share in global reserves, has intensified. Given the increasingly multipolar nature of geopolitics, some diversification looks inevitable as countries fear the security of their reserve assets. So-called ‘non-aligned’ nations that have declined to support US-led sanctions are looking to shield themselves against any risk of repercussions for continuing to trade with Russia. China has already tried to increase its use of the yuan to settle international trades.
While the dollar’s share of global reserves is currently at its lowest since 1994, according to the latest data from the International Monetary Fund, it retains a share above 40% and unquestioned dominance as the world’s reserve currency. Aside from the euro and sterling (prior to the 1970s), no currency has come even close as a competitor. Nearly 90% of all foreign exchange trades have USD on one side of the equation. The largest quantities of foreign currency reserve assets are held by the world’s central banks. There is simply too little foreign currency available worldwide to significantly diversify these portfolios. Alternatives to the US dollar (and US Treasury bonds) would be either less institutionally secure, less liquid, or offer a lower yield, or a combination of all three. China cannot argue that the yuan offers an alternative until it loosens capital controls. Excluding Russia’s yuan reserves, the Chinese currency accounts for just 2.7% of global reserves.
Meanwhile, to qualify as a dominant reserve currency, a country needs to be a source of global demand and run trade deficits, thereby exporting capital. In recent decades, the US trade deficit has widened as global dependence on the US consumer has increased. In practice, this means that many of the world’s exporters continue to rely on US spending, which no country is poised to replace for now. On the flipside, for many countries like Japan and Germany, continuing to operate a trade surplus is a source of national pride, while for others – like China – running a trade deficit could be problematic given current macroeconomic fragilities and the capital flight such a path may entail. Finally, reserve diversification flows, in themselves, are unlikely to drive currency movements. Private sector flows (in response to global macroeconomic factors) tend to be much larger and influential in driving currency movements. In summary, we do not believe that limited ongoing reserve diversification away from the dollar will be a big driver of dollar performance.
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