Will the US dollar give back any early-year gains?

A tightening of US monetary policy will support the dollar; allowing the currency to add to the modest gains that we saw last year.

Early in 2022, there seems to be a broad consensus that a tightening of US monetary policy will support the dollar; allowing the currency to add to the modest gains that we saw last year. But we are reticent to go this far. We do think that there could be some early-year strength in the dollar with euro/dollar, for instance slipping as low as 1.05- 1.10 but we don’t see a long-lasting dollar rally through the year.

By the end of 2022 we’d look for the euro to be back up to 1.20 or higher. We anticipate a stronger dollar in the short-term not so much for monetary policy reasons but because we remain nervous that tensions between Russia and Ukraine will spillover into a conflict that creates a period of risk-aversion that suits a stronger dollar. Monetary policy could play a secondary role to this factor early in the year.

Later in 2022, as the Fed gets on with rate hikes, we expect to find that the dollar is pretty unresponsive and actually gives back any early-year gains. There are a number of reasons for this view.

One is that the market is already running with reasonably elevated long-dollar positions as far as we can tell. Data from the CFTC on the positioning of non-commercial traders shows that the net long-dollar position is now some USD19.3bn when we add together the long positions against major G10 currencies (the euro, yen, pound, Swiss franc, Australian dollar and Canadian dollar). This is quite elevated in historical terms and could prove a headwind to further dollar gains.

A second factor is that the history of recent monetary cycles in the US have tended to show that the dollar strengthens as expectations of higher policy rates develop, but then weakens as these rate hikes are delivered. One caveat, in our view, is that this pattern is only likely to be repeated if the Fed delivers the rate hikes that the market anticipates which, for 2022, currently hovers between three and four. If the Fed has to go much faster, then the greenback could climb. However, even then it is likely that faster hikes will reflect soaring inflation and not super-robust growth and that will likely leave investors less enthusiastic about the dollar. For a start, rate hikes that just keep pace with inflation leave real rates unchanged and, at the end of it all, it is real rates that should impact currency levels, not nominal rates. Additionally, high and persistent inflation in the US will make the market fear that the Fed has lost control of prices and, in our view, this is not a bullish argument for a currency. Of course, dollar bulls could argue that others have lost control of prices as well as inflation is a worldwide problem. But, in our book, it is the US that is in the most dangerous place as it has stimulated the most, particularly on the fiscal side, and its new average inflation framework could lead to a de-anchoring of inflation expectations that is not repeated elsewhere.

If we stick with monetary policy for the moment, we’d argue that 2021 saw the dollar rise because expectations of tighter Fed policy gathered pace. Don’t forget, that in the December 2020 Fed meeting FOMC officials predicted that there would be no rate hikes in 2022. By December 21 this view had shifted to three hikes for 2022.

Looking ahead, Fed expectations could adjust further but it may be other central banks that provide the monetary surprises this year; banks such as the ECB and Bank of Japan. This might not come in the shape of actual rate increases but even if the pair lay the foundations for future hikes their currencies could eat into the dollar’s recent advantage.

On this score it is worth noting that we have already seen monetary policy shift quite a bit in the UK with the first rate hike in December and sterling has enjoyed a 5% trade-weighted rise in 2021; much of it late in the year as rate-hike expectations soared and the BoE delivered (Figure 2). If expectations start to move in a similar direction for the likes of the ECB and BoJ this year we could see the euro and yen fight back against the dollar in the same way as the pound has done late in 2021.