2024-01-08 12:39:35 ET
Summary
- The US Dollar performed poorly in Q4 2023, losing over 6% against a basket of currencies.
- Market expectations for a March rate cut by the Federal Reserve may be pushed back to May or later, supporting a dollar recovery.
- The Invesco DB US Dollar Index Bullish Fund ETF is a good way to gain exposure to a US Dollar upswing without holding futures contracts.
The US Dollar (DXY) performed poorly in Q4 2023 as the disinflation trend accelerated in the US and the Federal reserve made a dovish pivot. The DXY dollar index lost over 6% against a basket of currencies. However, I think it was pushed too far as dovish bets reached extreme and unrealistic levels at the end of December. The dollar is due a rebound.
Pushed Too Far
It's hard to bet against strong trends and even though we may feel they have extended too far, sentiment - specifically greed - can ensure they extend further. As the famous quote by John Maynard Keynes goes, "The market can stay irrational longer than you can stay solvent."
This was the case at the end of 2023. The uptrends in stocks and the downtrend in the US dollar were already stretched. The holiday season euphoria added to the situation and by the end of December, the dovish bets were excessive. The market seemed convinced the Fed will start easing as early as March and assigned a 90% chance of a rate cut according to CME .
It was a one-sided bet and when traders returned back from the Christmas break, they took the other side. The odds of a March cut dropped last week and the dollar rebounded. However, this could just be the start of a recovery as there is still a 65% probability assigned to a cut (or around 16bps priced in) and this has every chance to drop to zero.
May Or Later
Markets are betting on a March cut because of the accelerating trends in disinflation. By extrapolating these trends forward into 2024, they are estimating inflation meets the Fed's 2% inflation target in the next few months, which will allow them to start cutting rates rapidly.
This is speculative. The Fed's own dot plots indicate three cuts in 2024, while at the end of December the market was pricing in more than double that at 160bps. Moreover, the Fed have given no indication when they will start easing and the Minutes from the last meeting stated :
"Participants observed that inflation remained above the Committee's objective and that they would need to see more evidence that inflation pressures were abating to become confident in a sustained return of inflation to 2 percent."
CPI and PPI inflation reports will be released this week. CPI is expected to rise slightly from 3.1% to 3.2% y/y which would hardly constitute as "more evidence that inflation pressures were abating." This means the Fed will likely keep the same view in the January FOMC meeting and won't commit to a timetable for the first cut.
As well as disinflation, the December dovish shift came from signs of slowing in the economy. The December Minutes specifically mentioned concern with the labor market.
"Several participants noted the risk that, if labor demand were to weaken substantially further, the labor market could transition quickly from a gradual easing to a more abrupt downshift in conditions."
These concerns seem misplaced in light of the latest Jobs Report. The headline NFP number beat significantly with a healthy 216k, the unemployment rate beat estimates and stayed at 3.7%, while average hourly earnings rose 0.4%, beating the 0.3% consensus estimate.
This is not the kind of data that merits an early start to the cutting cycle. On the contrary, stronger-than-expected readings like these will likely prompt the Fed to hold rates steady in March and look at May or even later as a starting point for cuts. This would be a clear dollar positive.
Not All About The Fed
Fed policy is only one determiner in dollar exchange rates. The DXY dollar basket is weighted against six other global currencies, with the Euro comprising 57.6% of the basket. The Japanese Yen and the British Pound are second and third in weighting with 13.6% and 11.9% respectively.
Clearly, then, central bank policy in other regions will influence the dollar and recently this has been an extra headwind as the ECB and BoE have remained hawkish while the Fed pivoted. This is from Reuters last month :
"The U.S. Federal Reserve was left in a camp of its own on Thursday when a host of Europe's central banks stuck to plans to keep policy tight well into next year, dashing any hope that the Fed's pivot towards rate cuts marked a global turning point."
Despite the hawkish rhetoric of the ECB and BoE, the market priced in cuts anyway. Around 100bps of easing is expected from the ECB in 2024. However, this is still less than the 150-160bps priced in for the Fed. Furthermore, the EU economy is much worse shape than the US and the ECB has traditionally had the much more dovish policy. In short, there seems little reason for there to be such a wide spread between Fed and ECB policies and there could be an evening up of expectations in the coming months. This would weigh on the Euro and consequently boost the dollar.
An ETF For Dollar Exposure
For investors who want dollar exposure and don't want to trade specific US Dollar Futures Contracts, the Invesco DB US Dollar Index Bullish Fund ETF ( UUP ) is a good alternative. The "DB" in the title refers to the Deutsche Bank Long USD Currency Portfolio Index - Excess ReturnTM (DB Long USD Currency Portfolio Index ER or Index) it seeks to track.
The fund has assets under management of $365.7MM and has the following holdings:
UUP does pay an annual dividend from its holdings which last year was $1.75, issued in late December. This explains the gradual outperformance (accrued dividend) and large drop in share price in December when compared to the DXY.
Early 2024 could be a good time to buy this fund, both for the upside in the US dollar, and for this year's potential dividend. However, the latter is variable and previous year's have paid out much less.
Conclusion
The US dollar was pushed down on excessive dovish bets in December and these look set to reverse. A March cut could be pushed back to May or beyond. Furthermore, the relatively hawkish expectations for the ECB and BoE seem untenable given the US economic outperformance and policies are likely to converge.
UUP is a good way to own US dollar exposure for a move higher in early 2024. It replicates the dollar basket's weighting against six foreign currencies and pays a dividend.
For further details see:
UUP: Position For A Dollar Bounce As Dovish Bets Unwind