Dollar's Strength and the Path Ahead

Even if we still expect the dollar to turn lower by early 2024, USD upside risks remain material in the near term after the Fed surprised with more hawkish dot plots than market pricing. That may look like a reboot of June’s market conditions, but this time, the room for hawkish repricing in US short-term rates (and USD upside) is smaller.

USD: End of a strong quarter

This week marks the conclusion of the third quarter. The US dollar has exhibited strength throughout the summer, appreciating against all G10 currencies except the Norwegian krone (NOK). As we assess the near-term outlook, it appears unlikely that this trend will shift. The recent dot plot projections released by the Federal Open Market Committee (FOMC) suggest that the Fed is not yet prepared to signal the end of its tightening measures. Instead, a more aggressive "higher for longer" stance has emerged, with the median 2024 rate forecast now standing at 5.1%.

Back in June, when the Federal Reserve presented more hawkish dot plots compared to market expectations, I highlighted a significant upside risk for the dollar. Unless economic data starts indicating a slowdown, markets would eventually need to align themselves with the FOMC's projections. Although the current situation resembles that of June, the gap between the dot plot and market pricing has narrowed.

At present, markets are pricing in an end-2024 Fed rate of 4.67% (effective rate), implying a 65-basis point reduction from current levels. If the 2023 rate hike, as indicated in the Fed dot plots, is not ultimately realized, the theoretical median 2024 rate projection would decrease to 4.85%. This leaves approximately 20 basis points of potential repricing room should US economic data remain robust.

Comparing the current scenario to June, the gap between market expectations and dot plot projections was much wider. At that time, investors anticipated rates dropping to around 4.0% by the end of 2024, in contrast to the median dot plot projection of 4.65%.

I continue to emphasize the likelihood of more near-term upside risks for the dollar, as evidence of a slowdown in US economic activity may take longer to materialize. However, I anticipate that such evidence will eventually emerge, leading to a significant dovish repricing in US interest rates and a sharp decline in the dollar in 2024. Nevertheless, these near-term upside risks for the dollar and short-term US yields are not as prominent as they were in June when the disparity between market pricing and dot plot expectations for 2024 was more substantial.

This week is expected to be relatively quiet in terms of US economic data releases, with the focus primarily on speeches from Federal Reserve officials. Neel Kashkari, known for his hawkish views, is anticipated to support another rate hike and possibly oppose rate cut expectations. Later in the week, we will also hear from Fed Chair Jerome Powell. Generally, Fedspeak may not have as significant an impact on the market as economic data, but during a calm post-FOMC week, it can influence market sentiment, particularly with quarter-end flows in mind. The US Dollar Index (DXY) remains on course to surpass the 106.00 mark in the short term.

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