Understanding why the dollar has weakened so sharply in recent months is paramount: it is all about its safe-haven risk premium, China's zero Covid, European energy and US inflation/Fed hawkishness all drove a massive increase in the dollar risk premium throughout the year. Those three risks marked an absolute peak in November, allowing for a sizeable USD turn.
The dollar's previously huge risk premium now looks far less stretched (chart 1), accompanied by a shift in speculative positioning to neutral (chart 2).
The question now is, can the USD embark on a more sustained downtrend? Not yet is our answer.
First, from a market perspective, there is no signal that the dollar's anti-risk parity regime is changing. The USD continues to behave as the perfect hedge to a long bond/equity portfolio with little pressure on the market's dollar cash allocation to shift as it fulfills its intended purpose (chart 3).
Second, to become confident dollar bears, we must strongly believe that global macro conditions are shifting from a stagflationary to a reflationary environment.
On our yield curve framework, this would equate to a US bull steepening driven by real rates (chart 5) and a convincing low in equities (chart 4).
Both metrics have been important dollar bearish markers in the past. Third, we would need to believe that a shift in Fed bias towards easing is coming soon, eroding the dollar's position as a high-yielding currency. The dollar has historically never embarked on a big downtrend when it is a high yielder (chart 6).
As our Global Outlook argued a few days ago, we are still far from those conditions falling into place and, by extension, do not see a case for a sharply weaker dollar. On the flip side, the argument for a dollar return back to its peaks is weak too. The severity of the conditions at the dollar's peak cannot be underestimated: a (UK) fiscal crisis, an open-ended Chinese lockdown, European natural gas prices at 300 Mwh and sustained upside surprises to US inflation. The bar for returning to such a large cumulation of global risks is exceptionally high.
Bringing it all together, we are left with a neutral dollar view as the turn of the year approaches, in line with an L-shaped inflection point in this year's trends rather than V. With the FX market entering a much choppier phase, this leaves significantly greater scope for idiosyncratic FX moves, a topic we will return to in our upcoming Blueprint for 2023. ( via DB)
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