Turning more negative on the US dollar

IT HAS been a stand-out year for the US dollar (USD), driven by the widening policy and rates outlook as well as safe-haven flows. As we head into 2023, we look at several reasons that could justify a peak in the USD.

USD valuations look stretched

The USD appears to be overvalued, especially after this year’s blistering run. A look at the real effective exchange rate shows that it is currently more than one standard deviation above its historical average. This has only been reached twice – before 1972 when the USD was still on the gold standard, and during the 1980s when the Fed hiked rates to record highs. We believe that the current backdrop is far from such extremes. For confirmation, we also look at purchasing power parity, which similarly suggests that the USD is overvalued against eight of nine Group of Ten currencies (except the Swiss franc), including a whopping 30 per cent overvaluation against the yen.

The overvalued USD sets up ripe conditions for a potential correction, driven by a reversal of main USD drivers seen this year, namely widening policy rate differentials and safe-haven flows. Furthermore, we also see catalysts emerging for major constituents of the DXY Index (US Dollar Index), which could in turn result in a weaker dollar next year.