US Dollar Q1 Outlook: Weak Start, Strong Finish Dynamics

Explore the Q1 dynamics of the US Dollar – from a weak start to a strong finish in this fundamental outlook.

US DOLLAR – MARKET RECAP

As measured by the DXY index, the US dollar started the fourth quarter on the front foot, briefly reaching its most vital position in almost a year. Bets that the Federal Reserve would keep a restrictive stance for an extended period to restore economic price stability catalyzed the steady and consistent rise in US Treasury yields, underpinning these gains.

However, the greenback was unable to maintain its upward momentum for long. Shortly after setting a new 2023 high in early October, DXY shifted lower, undercut by the sharp downward correction in real and nominal yields following benign inflation readings.

With inflationary forces downshifting, markets began to price in aggressive rate cuts over the next few years to front-run the FOMC’s next easing cycle. The US central bank initially resisted the pressure to pivot but relented at its December meeting when it indicated that “talk” of cutting borrowing costs had already begun.

The Fed’s pivot accelerated the yield pullback, sending the 2-year note below 4.40%, a significant retracement from the cycle high of 5.25%. Simultaneously, the 10-year note plunged beneath the 4.0% threshold when, weeks earlier, it threatened to breach the psychological 5.0% level. The US dollar index plummeted in this context, hitting its weakest point since August.

US Dollar Q1 Outlook: Weak Start, Strong Finish Dynamics

The Fed’s unexpected dovish pivot is a clear signal that officials want to shift policy in time to engineer a soft landing; in other words, they are prioritizing growth over inflation. This bias won’t change overnight but will likely consolidate further in the near term, so the path of least resistance remains lower for both bond yields and the US dollar, at least for the first couple of months of 2024.

Navigational winds, however, could shift in favor of the greenback by the end of the first quarter, when additional data will become available for a more complete assessment of the macroeconomic picture.

The substantial easing of financial conditions noted in November and December, sparking a robust upturn in stocks, is poised to enhance the wealth effect as we enter the new year. This, in turn, is expected to contribute to robust household consumption, a pivotal driver of GDP. Consequently, one should only partially dismiss the possibility of an economic upswing in the medium term within this framework.

Any reacceleration in growth should boost employment gains and reinforce labor market tightness, putting upward pressure on wages. In this environment, inflation could settle well above the 2.0% target while staying skewed to the upside, preventing the Federal Reserve from pursuing a forceful easing campaign.

Although there is a heightened optimism regarding the US inflation outlook following encouraging CPI and Core PCE reports in the latter part of 2023, it is premature to declare victory. Any pause in progress or an upward reversal of the underlying trend in consumer prices next year could be cataclysmic for sentiment, prompting a hawkish repricing of interest rate expectations.

WINDS MAY SHIFT IN FAVOR OF THE US DOLLAR LATE IN Q1

As the transition from Q1 to Q2 approaches, traders may finally realize that the Fed won’t have the flexibility to cut rates as aggressively as once discounted. Adjusting to a new reality and shifting market assumptions, US yields could stage a moderate comeback, fostering optimal conditions for the US dollar to rebound more sustainably against its major peers.

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