Bet on a falling US dollar as the Fed is likely to flip, says TS Lombard

It’s time to gamble on a falling US dollar as it looks like the Federal Reserve will cut interest rates before the end of the year as its eurozone counterpart, the ECB, continues to tighten monetary policy, strategists at TS Lombard in a Wednesday note.

“This week we are shorting DXY futures…,” Skylar Montgomery Koning, senior global macro strategist, and Andrea Ciccone, chief research officer at TS Lombard, said in a note Tuesday. They referred to futures contracts on the ICE US Dollar Index DXY,
a measure of the dollar against a basket of six major currencies.

The US dollar went on a rampage in 2022, rising to multi-decade highs against major counterparts including the euro EURUSD,
which traded below parity for the first time in more than two decades along with the Japanese yen USDJPY,
and the British pound GBPUSD,
The ICE US Dollar Index rose to a 20-year high in October, but has since fallen about 15% and has recovered more than 50% of the rally from its low on January 6, 2021 to its high in October 2022.

The dollar soared last year as the Federal Reserve embarked on a breakneck rate hike, taking its benchmark interest rate from near zero to above 4% with a series of outsized measures in its bid to curb inflation. The Fed is now slowing the pace of rate hikes in 2023.

The Fed and market participants disagree on the rate path, with policymakers emphasizing their expectations that the Fed Funds rate, now at 4.25% to 4.5%, will rise above 5% and remain there for some time. Money markets show that participants expect Fed Funds rates to fall below that level and possibly fall before the end of the year.

TS Lombard said his chief economist, Steve Blitz, expects slowing inflation to lead the Fed to end the tightening cycle by just under 5%, with a rate hike of a quarter point in February, possibly the last of the cycle. He expects interest rates to be cut midway through the year as the market starts pricing in a recession, which would put downward pressure on government bond yields.

While the Fed led central banks in tightening policy in 2022, causing US interest rates to rise relative to global government bond yields and the dollar to rise, that dynamic has reversed this year, the strategists say.

“Furthermore, the 2-year differential that heralded the dollar’s bullish turn in June 2021 has now moved upward in favor of the euro for the first time since,” they wrote (see chart below).

TS Lombard

As for the euro/dollar currency pair, the question for investors will shift from will the Fed cut rates in 2023 to “how deep,” the analysts said. Meanwhile, the European Central Bank is likely to stick with an aggressive series of rate hikes signaled at its policy meeting in December.

“The ECB has a preference for overtightening, but also started its tightening cycle later than the rest [developed-market economies] and thus has resulted in less cumulative tightening,” they wrote. “This means European rates are less restrictive, giving the bank more room to raise and then pause at this stage of the cycle. Interest rate markets seem to reflect this view: as far as the ECB’s cuts in 2023 are concerned, little has been priced in at this stage. So there will probably come a period where the story is one of Fed-ECB policy convergence.”

However, they added a caveat.

“There seems to be a limit to how tight the market thinks the ECB can get: the higher the market-priced ECB final interest rate, the more market prices fall,” they said. And since a US recession would exacerbate an EU recession, the ECB should probably follow the Fed in cutting rates at some point.