Expect the next move in interest rates to be lower.

Federal Reserve Chairman, Jerome Powell, surprised financial markets with unexpectedly dovish comments regarding the trajectory of interest rates going forward. As expected, the FOMC left interest rates unchanged at the final policy meeting of 2023. In the ensuing press conference, Powell said that the committee discussed the question of “dialing back the amount of policy restraint,” indicating the likelihood of rate cuts in next year’s meetings. He shared the “dot plot” of expectations among committee members which indicated a high probability of three rate cuts before the end of 2024. This was seen as a stark reversal of his previous stance of “higher for longer.”

Unsurprisingly, global financial markets reacted sharply. US bonds and equities rallied strongly (the Dow Jones average hit a new all-time high), the dollar (DXY) had its biggest single-day drop in over a month, and every major currency moved up against the dollar.

The dollar continued its fall the next day, pressured by announcements from the central banks of Europe and Great Britain that expressed a decidedly different set of expectations for future policy. The European Central Bank left rates unchanged as ECB President Lagarde made it clear that, “We should absolutely not lower our guard,” adding, “We did not discuss rate cuts at all.” Likewise, the Bank of England kept rates at a 15-year high as BOE Governor Bailey said, “there is still some way to go.” 

After its biggest two-day drop since July, the dollar recovered some of its losses on Friday. The dollar’s bounce was partially attributed to oversold technical conditions, but was mostly driven by the market’s reaction to weak economic reports from both the eurozone and England. Many analysts believe that despite their hawkish rhetoric, the ECB and BOE will likely join the Fed in cutting rates next year, and they each may wind up cutting rates more than the Fed.

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What to Watch with a Fed Rate Pause

Powell’s policy pivot was driven by clear evidence of declining inflation. The Fed will carefully monitor future data to see if the disinflationary trend continues. With that, the Fed interest rate effect on the economy will be clear shortly, as markets will be paying close attention to the release of the Core PCE (Personal Consumption Expenditures) Index on Friday, 12/22, as well as CPI and PPI reports to be released on January 11 and 12. The Fed will also be looking for evidence of any weakening in the jobs market to confirm its new, dovish stance. On the other hand, if inflation picks up and job creation remains strong, it will be seen by the market as a reason for the Fed to postpone any rate cuts.

Much of last week’s drop in the dollar was due to speculators exiting long positions, as well as hedgers lifting protection against a rising greenback. The key to the direction of the dollar will be the relative strength of the US economy compared to economies of other major industrialized nations. 

Europe appears to be slipping into recession as the most recent Purchasing Managers’ Index showed contraction for the seventh consecutive month. The Bank of England now expects GDP to be flat in the fourth quarter of 2023 after the economy shrank in October, a downward revision from the 0.1% quarterly growth expected in its November forecasts.  The Japanese yen has had the best recent performance against the dollar, gaining ground in five consecutive weeks, as the BOJ has hinted that it intends to start raising interest rates in 2024. Most analysts believe that the yen is still significantly undervalued against the dollar, so any increase in Japanese rates could accelerate the yen’s rally.

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DXY Forecast: The Dollar in 2024

The majority of analysts are predicting a lower dollar in 2024 for their DXY forecast, but Morgan Stanley, HSBS, and JP Morgan are all forecasting a rise in the dollar as the US economy continues to outperform its global peers. “It is peculiar that the consensus thinks the US dollar will be the loser in 2024,” said Paul Mackel, global head of FX research at HSBC. “A number of scenarios point to dollar resilience but only a global soft landing delivers a clear dollar bear case.”

Market technicians will be closely monitoring DXY’s 2023 range of approximately 100 to 107. A break below the 2023 low will likely set the stage for a test of the 90 level, last seen in 2021, while a move above 107 could result in a move to retest the 2022 high of 114.

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Looking at this DXY forecast, Pangea believes that the dollar will most likely rise gradually in 2024, with its performance varying from country to country. It is quite probable that the dollar will gain against some currencies and lose to others. FX markets are expected to be more volatile than 2023, which means that for many businesses operating globally, their FX risk and exposure will also be more volatile.

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