Dollar rises amid low liquidity

Written by Convera’s Market Insights Team

Dollar faces first test of the year already

Boris Kovacevic – Global Macro Strategist

Global equity markets took a breather on the first trading day of 2024 amid low liquidity and a lack of important macro data. The tech-heavy Nasdaq fell by 1.40%, while the broader S&P 500 shed around 0.44% of its value. The MSCI World Index fell by 0.6% on Tuesday, after having recorded nine positive weeks in a row. While it will take some time for traders to be back on their desks and for volatility to pick up again after the end of the holiday season, key economic releases are coming up this week already. US investors will be focused on the purchasing manager index for the manufacturing sector and the FOMC meeting minutes today with attention shifting to the non-farm payrolls report on Friday.

The backdrop going into these three data points has been dollar negative. The assumption of the Federal Reserve starting an aggressive easing cycle starting somewhere between March and July has pushed down government bond yields in the United States, in the process weighing on the Greenback. The US Dollar Index (DXY) had fallen by 5.5% from October to the end of December, inversely tracking the 15% rise in US equities over the course of the last two months of 2023. DXY (102.12) has started the year on stronger footing and is on track to record its first positive week since the beginning of December. However, this is conditioned upon the US labor market remaining robust. The US economy added 199 thousand jobs to its workforce in November, with economists expected a step down to 150 thousand in December.

Any surprises on the data front will have the potential to influence Fed pricing and therefore the dollar. Markets are currently playing the first rate cut into March with a probability of around 70%. For the whole year, investors see six rate cuts each worth 25 basis points as the basis scenario, which would put the Fed’s policy rate at 3.75% – 4.00% in December 2024. US policy makers see three rate cuts as likely based on their latest rate projections from the dot-plot.

Hopes of a policy-induced turnaround

Boris Kovacevic – Global Macro Strategist

The year 2023 won’t be remembered as a good one for the European economy, which is still struggling with the high global interest rates regime and is on the cusp of entering a technical recession. The Eurozone’s manufacturing sector has been contracting for 18 consecutive months with the German economy expected to have stagnated last year. With the European Central Bank’s policy rate at a record high of 4%, loan growth to households has fallen to the lowest level since 2015. This has pushed inflation from well above 10% in 2022 to 2.4% in November.

While some leading indicators have started to signal a bottom of economic momentum, few economists or international institutions are forecasting this year to be any better than 2023. The lagged effect of the ECB’s rate hikes will most likely continue impacting the economy in the first half of this year. However, with inflation expected to continue its descent and to open the door for policy easing from the ECB, the second half of 2023 could show some improvement in sentiment and business investment. Markets have already started pricing in the regime shift in the European monetary policy, with the German stock benchmark DAX having touched a record high in December. This corresponds with markets pricing in rate cuts worth 150 basis points from the ECB for 2024.

The euro has finally recorded its first positive year since 2020, rising by around 3% against the US dollar. EUR/USD has been through multiple ultra short-term (mini) cycles throughout last year, with each up and down period lasting just a few months. The $1.10 level now seems to act as an anker as investors are not comfortable enough to push the currency pair to neither the 2023 lows of $1.045 nor highs at $1.1270.

UK services sector continued to outperform

Boris Kovacevic – Global Macro Strategist

The British pound ended 2023 on a positive note, having risen by more than 5% against the US dollar and reclaiming it’s title as the second strongest G10 currency of the year. While markets have recently pushed up their expectations of aggressive policy easing from the Bank of England for this year, almost matching their rate cutting bets for the Fed and ECB, the pound remained supported by high inflation and surprisingly resilient economic data. However, both these factors have come under scrutiny. Inflation fell to the lowest level in two years in November, rising by only 3.9%. Food prices continued their descent at the end of the year as well, rising by 6.7% in December compared to a growth rate of 7.7% the month prior. At the same time, the British economy unexpectedly shrank in the third quarter, after having stagnated in the three months leading up to July.

Hopes of a quick revival of the manufacturing sector have suffered a setback with the latest release of the final purchasing manager index. The barometer for the health of Britain’s factories weakened from a seven-month high of 47.2 in November to 46.2 in December. The manufacturing sector has been in contractionary territory for the whole of 2023. However, the print had largely been ignored given the improvement of the services sector. The services PMI increased from 50.9 to 53.7, marking the second consecutive monthly expansion and the fastest increase since May.

The economic data will be key in determining how much of an outlier the British economy will be and how much the Bank of England can afford to keep rates at the currently restrictive levels. Markets have already committed to pricing in rate cuts worth 140 basis points for this year. GBP/USD suffered its worst day since October on Tuesday on falling Fed cutting bets, leaving the currency pair at around $1.2630. We are now trading around 1.5% below the multi-month high reached just before New Years Eve at $1.2820. The recent fall of the interest rate differential between the UK and US suggests some short-term downside potential as the currency pair continues to be positioned in the upper half of its 12- 24- and 36-month trading range