Currency investors are grappling with two competing narratives as the debate around the possibility of a US recession rages on. One camp believes that a recession is good for the US Dollar (USD). The other camp argues that excessively high valuations and narrowing interest rate differentials with the rest of the world should push the USD lower. Data suggests that the USD’s track record around a pause in Fed rate hikes and recessions is quite mixed. We are in the “weaker USD” camp. We believe that the USD’s weakening foundations should triumph over any temporary investor demand for a safe haven.
Separating fact from fiction
Nobel prize-winning psychologist Daniel Kahneman’s work offers some insights into how to assess the USD at this juncture. In his bestseller book “Thinking Fast and Slow”, Kahneman elaborates how the brain has two ways of driving our thought. “System 1” is the fast, instinctive way, where the brain uses experience and heuristics to arrive at decisions quickly. “System 2” on the other hand is the slower, more deliberate and logical way of decision-making, but is more resource intensive.
Looking at the past instances when the USD was stronger during some of the previous recessions and extending the same conclusion to today’s environment feels like a “System 1”-driven conclusion. It ignores the nuances of the USD’s behaviour around different types of recession. It also overlooks the changes in the global macro-economic landscape over the past 50 years.
So, let us take a “System 2”-based approach to assess the historical behaviour of the USD around past US recessions. This method is more detailed and fact-based.
Fig 1: The USD tends to strengthen during more broad-based global recessions; it exhibits weakness around US-led recessions
The US Dollar index (DXY); Grey shaded areas represent US recessions
Source: Bloomberg, Standard Chartered
- A quick look at Figure 1 suggests the USD strengthened around the recessions in the 1970s and 1980s, 2001 and 2020. A common feature of 2001 and 2020 recessions was that both were accompanied by a global slowdown, and the USD benefitted from safe haven demand.
- However, the USD weakened when recessions began in 1990 and 2007. Interestingly, both these recessions were primarily led by the US. In the case of the 2007 recession, the USD ultimately rebounded in 2008 as the financial contagion spread from the US to other countries, eventually turning it from a US to a global recession.
Hence, in our opinion, the nature of a US recession is a key consideration when thinking about implications for the USD.
The three factors arguing for a USD decline
A US recession appears to be looming again. We see an 80% chance of this happening in the next 12 months. This time, we see three drivers of further USD weakness:
- We expect a mild economic recession in the US, which is unlikely to spill over to the rest of the world. In fact, we expect strong economic growth in China and India. Also, the economic heft of China and India has grown over the past few decades and the weight of the US in the global economy has declined. As a result, we expect global growth to outperform that in the US this year. As the “US Dollar Smile” framework below illustrates, such an environment of strong global growth usually sees the USD weaken against other major currencies.
Fig 2: USD Dollar smile framework points towards a weaker US Dollar
Source: Standard Chartered
- Given our view of a US recession, we expect the US Federal Reserve to start cutting interest rates later in 2023. We expect it to accelerate the pace of rate cuts as we move through 2024. Meanwhile, we expect the European Central Bank (ECB) to raise rates further this quarter and then keep rates on hold at least for the rest of the year. The Bank of Japan is likely to tighten its monetary policy. Against this backdrop, we expect the US 2-year and 10-year government bond yields to decline, eroding the US’s interest rate advantage against its major trade partners. Remember that relatively higher US rates was one of the key drivers of the USD’s strength in 2022.
- Lastly, the USD still looks expensive relative to its underlying fundamentals, despite its nearly 10% decline from highs in 2022. It is no doubt challenging to time when the USD’s valuation would revert to its long-term average. Nevertheless, a moderation in valuations is likely to drive further USD weakness.
JPY and EUR are likely winners of a USD decline
We expect most of the major world and Asian currencies to strengthen versus the USD. Within this, we see the Japanese Yen (JPY) and the Euro (EUR) as potentially benefitting the most.
A decline in US bond yields should lead to a lower interest rate differential between the US and Japan. The rate differential has been a key driver of the USD/JPY pair since the pandemic. We believe the relative interest rates outlook argues for USD/JPY to decline towards 125 over the next 12 months. However, we see a risk of USD/JPY potentially testing 120, should the Bank of Japan turn less accommodative in its monetary policy.
We often look at the EUR as an ‘anti-Dollar’ currency. Indeed, we expect the EUR to be one of the main beneficiaries of a weaker USD in the next 3-12 months. Given still-elevated inflation in the Euro area, the ECB could hike rates by another 50bps to 3.5% next month. It is then likely to keep rates on hold at least till end-2023, giving the EUR an edge over the USD. Lastly, the Euro area’s lower energy import costs could cause a current account surplus over the next 12-18 months. When combined with improved portfolio investment flows and economic sentiment, this should result in a stronger EUR/USD, potentially pushing the pair towards 1.13-1.15.
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