Technical Analysis

Two reasons why you should not to discount the dollar

The bond market is certainly not buying what the Fed is selling at the moment. That says something but if there is any key takeaway, it is that it does not bode well for the dollar outlook if broader markets are taking charge instead of the Fed heading into next year.

So, what’s next for the dollar? It is either markets get it wrong and the Fed gets it right; vice versa. As such, here are two reasons why you should not count the dollar out just yet.

US rates and the economy

There simply isn’t a better place to be right now, arguably. With there being reason for a ‘soft landing’ (it might have to come down to the housing market), and should the Fed manage that, it’s a case of the US economy being the cleanest shirt among the dirty pile of laundry.

Add that to the fact that after the aggressive rate hikes, you still end up with the US having the highest interest rates among major economies. What’s there not to like? Sure, the bond market might argue otherwise as yields fall off but let’s not be naive into thinking that if Treasury yields do fall off significantly, bond yields elsewhere are also going to take a cue surely.

If you look at Europe and the UK, their economies suck even harder amid the energy crisis and cost-of-living crisis. The only argument might be for Japan if the BOJ starts to pivot into more hawkish monetary policy next year.

That said, here’s a reason why you shouldn’t buy into this narrative.

This is also very much the case for having been long the dollar throughout 2022. Let’s not kid ourselves that dollar positions are still favoured towards longs at this stage and there’s still some unwinding left to do should markets retrace further.

As has always been the case, the consensus trade in markets is often times the most dangerous – especially when there are reasons for a pullback. Things can get violent and that is definitely the case for the dollar since November.

After all, if Treasury yields fall off in a material manner, that removes one key tailwind for the dollar that has given it such an exceptional booster this year.

Inflation, inflation, inflation

There is a difference between an inflation peak and an inflation plateau. The former will be a key motivator for broader market sentiment to keep running up against the Fed but if inflation does turn out to be more sticky, it could very well be the case that we see rates stay in more restrictive territory for a longer period – which is what the Fed is saying now.

So, essentially the inflation narrative is one that is also synonymous to the Fed outlook.

It is either markets get their wish that inflation falls down materially and moves closer towards 2% during the course of next year, or that inflation actually turns out to be more sticky and that makes its way into core inflation as well – holding at around 4-6% perhaps.

There are plenty of moving parts involved in weighing up this outlook, from China’s re-opening to any potential rally in the commodities space. It’s going to be one of the toughest things to try and grasp looking towards next year.

If inflation does prove to be more persistent, the Fed outlook becomes more justified. That will vindicate dollar bulls as it means we are headed towards a more stagflationary environment i.e. a likely deeper, prolonged recession with higher rates to try and keep inflation in check.

And here’s a reason why you shouldn’t buy into such a development.

That is if the Fed is wrong and inflation does come off more quickly than anticipated. That will allow scope for the Fed to be more flexible in terms of policy, which means rate cuts will start to come into the picture.

If that is the case, cue the euphoria for risk trades and one can safely say that dollar bulls will very well have to wave their white flag.

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