Macroscope | US dollar bulls could be skating on thin ice

Recent speculation that the Federal Reserve will raise interest rates significantly this year has boosted US dollar sentiment

However, with the jury still out on economy recovery and the Fed less likely to go for overkill on inflation, it won’t be too long before interest rate expectations level off

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People walk past currency notes displayed outside a currency exchange in Sheung Wan, Hong Kong, in October last year. China’s renminbi could be a clear candidate for investors looking for attractive short dollar currency plays. Photo: Yik Yeung-man

Published: 9:30pm, 27 Feb 2023

Don’t get your hopes up that the US dollar is enjoying a sea-change in fortunes. In fact, there is every chance dollar bulls are skating on thin ice after recent speculation that the US Federal Reserve is adopting a tougher guard against inflation.

The Fed seems set to take the key funds rate to a peak between 5 to 5.25 per cent in the next few months, but there’s still scope to ease policy before the end of the year to give the US economy a boost as the Fed’s focus switches from inflation to growth.

The dollar will lose its shine as interest-rate expectations level off, safe haven demand declines and investors seek better opportunities abroad. A weaker dollar might bring a welcome break for US exporters, but other nations might not be so happy to lose a vital source of export-led support.

It’s true that there has been some modest realignment in US interest rate perceptions in recent weeks as the economy has performed better than expected. US inflation fears have eased considerably and the economy is in a better place, but the Fed’s attention may now be focused on stronger-than-expected domestic demand, leaving little scope for the central bank to soften on its apparent commitment to toughen up policy.

US consumer price inflation has fallen quite sharply from 9.1 per cent in June last year down to 6.4 per cent in January, but booming employment conditions and a 3 per cent surge in retail sales in January have muddied the waters, challenging hopes about how soon US interest rates might eventually come down.

As inflation pressures progressively eased, US money market futures had taken a more dovish view of Fed policy intentions, looking for the funds rate to peak at 5 per cent in the next few months but with the possibility of lower interest rates creeping in before the end of 2023. More recently though, on the back of stronger real economy data, money markets have revised expectations for a possible peak in Fed funds up to 5.4 per cent, with little chance of a rate cut until 2024.

It’s provided a positive boost for US dollar sentiment, which has seen the trade-weighted currency index, representing the dollar against a basket of other major currencies, gaining ground to the tune of 4 per cent over the last month.