US dollar entering extreme territory

US dollar entering extreme territory

But short-term outlook for the US dollar remains positive.

There has been continued strengthening of the USD in recent weeks, to the point where it looks overstretched from a historical perspective. The combination of a resilient domestic economy and the Fed’s aggressive monetary stance have been particularly supportive of the US dollar. While a Fed pivot to a less aggressive stance would go a long way to reducing upward pressure on the dollar, one also has to consider that there has been a deterioration in the domestic drivers of rival currencies, pushing them down and adding to the upward pressure on the dollar. A change on this front may be needed to force the US dollar lower in any meaningful way.  

In particular, the euro has been hurt by a stagflationary shock exacerbated by the war in Ukraine. While unexpected European Central Bank hawkishness has managed to provide some support to the single currency, the euro area economy remains exposed to high energy prices and rising yields. The euro could find some further relief if, as a recent OECD report asserts, the euro area manages to get through the winter without further energy shocks. But it still remains to be seen how high energy import costs will impact economic activity beyond this winter. Higher yields in the euro area could also have unintended consequences. In particular, rising interest costs will be a challenge for highly indebted countries like Italy.

Overall, while we acknowledge that the US dollar is extremely expensive, and while we see catalysts (notably a pause in the Fed’s tightening cycle) for a decline in the US dollar’s value at some stage, over the next two months we see few pointers to significant US dollar weakness. We have thus decided to set our new three-month projections at USD0.95 to take account of further possible short-term strength in the US dollar. However, we are sticking to our 12-month projection of USD1.07. We will adjust our projections for other dollar crosses following the same rationale.

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