US Dollar Index Forecast 2023 – Fed Rate Hikes, Recession-Driven Safe-Haven Buying to Provide Support

The relentless rally by the U.S. Dollar in 2022 devastated foreign currencies, chewed up multi-national corporate profits and handed investors one of the best trending trades of the year. And even though the greenback has struggled since late September, recession concerns may keep it elevated in 2023.

At its peak on September 28, the U.S. Dollar stood at its highest level against a basket of major currencies in nearly twenty-years after rising about 20%. However, those gains have been roughly cut in half as investors bet the Federal Reserve is edging closer to slowing the pace of its rate hikes that helped fuel the greenback’s earlier gains.

Rising Yields, Safe-Haven Buying Back the Buck

The Federal Reserve’s aggressive rate hike campaign led to higher U.S. Treasury yields, which proved to be the catalyst for most of the dollar’s strength. However, other factors played an important role in boosting the buck.

Investors also gravitated to the dollar – a popular safe-haven during uncertain times – to shelter from heightened market volatility, fueled by surging global inflation, soaring energy prices and Russia’s invasion of Ukraine.

Another factor that contributed to the U.S. Dollar’s appeal was the comparative strength of the U.S. economy during a time when an energy crisis in Europe hammered assets and brought the continent to the brink of recession. Additionally, China’s economy struggled to gain traction due to stringent COVID-19 restrictions.

Dollar Remains on Pace to Post Best Performance in Eight Years

Even with the fourth quarter sell-off, the U.S. Dollar remains on track to post its best year since 2014. Although predictions of an easing of Fed tightening started the retreat, some blamed fund managers who called the long-dollar trade the “Most Crowded Trade”. In other words, they sold the dollar because they thought it was fundamentally overvalued and technically overbought.

Nonetheless, a recent Reuters poll of 66 foreign exchange strategists suggested the dollar will trade at its current level around a year from now, with many expecting global central bank policy tightening to hurt growth and boost the greenback’s safe-haven appeal once again.

Why the Dollar Matters to the Global Economy

Predicting the direction of the dollar is important across the entire financial market spectrum. It trajectory sets the tone in everything from corporate earnings to the prices of raw materials such as oil and gold.

Specifically, a stronger U.S. Dollar makes U.S. exporters’ products less competitive aboard while hurting U.S. multinationals who get paid in foreign currencies that they need to exchange into more expensive dollars. This exchange risk hurts corporate earnings.

The S&P 500’s foreign exposure stands at around 30%, according to Bank of America, with the technology and materials sectors most vulnerable. Furthermore, the dollar’s rally clipped about 8% from S&P earnings in 2022, according to Tom Lee, head of research at Fundstrat Global Advisors.

The global economy also struggles when the dollar is too strong. A stronger U.S. currency pressures the price of crude oil and other dollar-denominated commodities by making them more expensive to foreign buyers, while also making it more expensive for foreign companies and governments that have borrowed in dollars to service their debt, according to Reuters.

And while a strong greenback can tamp down U.S. consumer prices, it also pushes down the currencies of other countries helping exacerbate inflation around the globe. On average, the estimated pass-through of a 10% dollar appreciation into inflation is 1%, the International Monetary Fund estimated in October.

2023 Outlook

Investors will be honing in on consumer inflation in early 2023. This is because the dollar’s decline from its 2022 top began to accelerate when data started showing that consumer prices fell less than expected in October. That news helped fuel a 5% drop in the greenback against a basket of major currencies in November, its biggest monthly decline since 2010.

Sentiment also shifted in late 2022, when speculative futures traders swung into a net short position on the U.S. Dollar for the first time in 16 months in November. That being said, we are expecting the market to start the new year with a net short dollar position.

Fed Will Be Key to Dollar’s Direction

The ability to sustain the dollar’s late year bearish tone will depend on the Fed’s ability to contain inflation enough to eventually ease monetary policy.

While we don’t think the dollar will return to its 2022 high next year, we think it will continue to receive enough support to prevent a complete collapse.

One reason why the dollar could stabilize early in the year is because of the Fed’s hawkish tone at its December 14 meeting. The dollar was falling into the meeting as traders priced in a softer tone from policymakers. However, the greenback hit a short-term bottom at 102.875 after Fed policymakers said they expect to raise U.S. interest rates further, and keep them high for longer, than they had anticipated.

Furthermore, they said that squashing high inflation will likely take a bigger toll on the economy and the job market than they had hoped.

And though Fed Chair Jerome Powell said that the Fed’s latest policymaker projections don’t necessarily mean the economy will fall into a recession, he did suggest the risk is worth it, and the Fed has no plans to cut rates to cushion the blow.

Two Major Price Swings in 2023

We believe there are going to be two major moves in the U.S. Dollar in 2023. We are expecting the first move  to be to the upside with the greenback supported by the Fed’s rate hikes and a recession.

Higher rates will continue to make the dollar an attractive asset, while a recession will increase its appeal as a safe-haven currency.

After the mild recession, the Fed is likely to hold rates steady or even talk about a rate cut. That would put downside pressure on the dollar index.