Fredrik Repton, senior portfolio manager at Neuberger Berman, sounds a note of caution with his latest analysis into the outlook for the US dollar
Despite the solid performance of risky assets so far this year, we believe that investors should temper their expectations for U.S. dollar weakness.
Over the last two months of 2023, the U.S. dollar, as measured by the DXY index, depreciated by 5%. This weakness was largely driven by the so-called Fed pivot, which pushed risky assets—normally funded through the dollar—to highs for the year. However, despite the solid performance of risky assets so far in 2024, we believe that investors should temper their expectations that the dollar will follow last year’s script.
First, the late-2023 dollar decline was not fully supported by interest differentials. While expectations for Federal Reserve rate cuts increased materially, so did expectations for cuts by other central banks. The effect was that the two-year interest differential—an important driver of exchange rates—did not shift materially against the dollar. In addition, the absolute level of interest rates supports the dollar: The implied interest differential in a one-year forward contract between the dollar and the euro remains at 1.6% in the dollar’s favor despite all the excitement about the Fed’s easing cycle.
The outlook for growth and inflation may also be a barrier to significant dollar weakness. This year, growth in the euro area is again expected to be weaker than in the U.S., while inflation, based on both headline and core measures, is now at higher levels in the U.S. than in the euro area. Underlining the firmer growth and inflation dynamics in the U.S. is the stark difference in fiscal stance. This is expected to continue over the course of the year, possibly (as some analysts expect) supported by increased impacts from the Inflation Reduction Act.
Finally, the geopolitical landscape should help the greenback. Market participants seem to have been caught off guard by Donald Trump’s strong electoral showings in Iowa and New Hampshire. His continued success could cause investors to revisit the playbook from his previous term as U.S. president. In addition, policy uncertainty in Europe, China and Russia is considerable—and policy uncertainty has historically boosted the dollar.
Putting all these factors together, we believe that the U.S. dollar—already overvalued on some long-term fair value estimates—is likely to stay in a broad range but strengthen modestly this year.
