The Dollar Index has fallen over 8% from the multi-decade highs printed in September, moving from around $114 to $105. As we round out the year, traders are now questioning whether the downturn marks the start of a reversal lower, or if this is simply a correction within the longer-term bull trend.
With that in mind, let’s take a look at the factors impacting the US Dollar currently and how they look set to develop over the coming months as we transition into 2023.
Changing Fed Expectations
The biggest driver behind USD price action currently is the shifting expectations for Fed policy. An increasingly hawkish approach from the Fed over the year saw USD surging higher as traders reacted to rising yields and rising rate-hike projections. The inflationary backdrop has been the backbone of the rally. With CPI surging to almost 500% above the Fed’s 2% target, traders were quickly moving to price in even more aggressive action from the Fed, reflected in the sharp uptick in USD long exposure.
Over recent months, however, the picture has changed somewhat. With inflation seen cooling sharply in October, and some members of the Fed voicing support for a slower pace of rate hikes, some players have begun scaling back their USD long positions, anticipating a shift in approach from the Fed. The idea of a so-called “Fed pivot’ gained further traction as other central banks such as the RBA and BOC made the decision to slow the pace of their own tightening programs, citing concern for the economy under harsher monetary conditions.
Indeed, the November FOMC meeting saw Fed chairman Powell acknowledging that a slower pace of hikes would soon become appropriate. The release of the meeting minutes subsequently showed that many members shared this view and, while no specific mention of December was made, market pricing has since move to reflect a higher likelihood of a smaller 50bps hike.
However, where pricing for a smaller hike was around 80% on the back of the October inflation reading, it now sits at 67.5% (CME group fedwatch). This shows that expectations are still a little split, highlighting two-way action heading into the December FOMC. Comments from Fed chair Powell tonight (Weds Nov. 30) will be closely watched by traders and have the potential to push market expectations one way or the other.
Powell Comments on Watch
If Powell is seen to be more dovish in his commentary today, this will likely bolster the view that a smaller hike is coming in December, pulling USD lower in the run up to the meeting. Alternatively, if Powell is seem striking a more upbeat tone – perhaps acknowledging today’s 3Q GDP reading which came in above expectations, confirming the US is out of recession, this might see USD bid as we approach the December FOMC meeting.
Looking to the December meeting then, regardless of which option the Fed goes for, the main focus will be on its outlook for Q1 2023. The key to gauging this will be the November US CPI reading which comes in just ahead of the FOMC on December 13th. With October CPI having slowed to 7.7% from 8.2% prior, a further downside move in consumer prices would reinforce the view that CPI has peaked, allowing the market to project a slower pace of hikes.
If this materialises, we might expect USD to further unwind in coming months as risk assets rally and global yields move lower. This view is in line with the sentiment expressed at the November meeting.
Given the trajectory of inflation since the summer peak, It would likely take a meaningful upside shock in November inflation to cause the Fed any reason to shift away from forecasting a slower pace of hikes in coming months. With this in mind, it seems more likely a case of when we see the next leg lower in USD, rather than if.
Dollar Index Weekly Chart
Source: FlowBank / TradingView
The correction lower in the DXY has seen the market moving down as far as a test of the 105.70 level which is holding as support for now. With price still above the bullish trend line, the uptrend remains intact for now. The key level to watch will therefore be the 103.00 support level with the rising trend line there also. A break of this area will be heavily bearish, opening the way for a move down to the 97.00 level in coming months.