After experiencing a historically strong year, the U.S. dollar appears overvalued against a broad basket of currencies, and macroeconomic fundamentals are poised to deteriorate in 2023.
This is the view of Brandywine Global portfolio manager Anujeet Sareen who provided a global currencies outlook for the next year.
He said the primary drivers of the dollar in 2022 were relative growth outperformance and relative monetary tightening.
Although U.S. real growth decelerated in 2022, the substantial growth shocks in Europe and in China led to relative U.S. economic outperformance.
In parallel, the Fed raised interest rates by 400 basis points (bps), more than nearly all other major central banks.
Relative monetary policy is set to move in parallel with the shift in relative growth, and the Fed is approaching peak policy rates near 5%.
However, the European Central Bank, given that its policy tightening cycle began later, may still raise interest rates further in 2023.
European inflation is likely to slow somewhat later, and fiscal policy is more supportive of growth in Europe than in the United States. This relative shift in monetary policy is constructive for the euro.
In Japan, monetary policy also is poised to begin tightening in 2023. Governor Kuroda, one of the principal architects of Japan’s aggressive reflationary monetary policies, is set to step down in early April.
While his successor has not yet been determined, the acceleration in Japanese inflation has increased the probability of tighter Japanese monetary policy, which would strengthen the yen.
Overall, the powerful rally in the dollar in 2022 was driven by an alignment of factors that will not persist in 2023.
The greenback is expensive, and relative growth prospects point to a weaker dollar next year.
Relative monetary policy will also tighten more outside the U.S., notably in Europe and possibly in Japan as well.
However, the Fed is unlikely to start easing monetary policy soon; hence, the positive carry offered by the U.S. dollar will support the greenback.
Balance sheet contraction will further diminish the supply of dollars, providing support to the currency.
In conclusion, the dollar has likely started a peaking process.
However, a sustained decline in the dollar will ultimately require the Fed to lower interest rates, end quantitative tightening, and provide some expectation of improvement for the global economy, notably outside the U.S.