Dollar’s best days may be over with traders front-running a hawkish Fed

“Historically the dollar has traded with strength in the six months preceding the first US interest rate hike,” said Arjun Vij, portfolio manager at JPMorgan Asset Management who sees the greenback gaining against the euro, Swiss franc and yen. But with two-to-three rate increases already baked into markets, “there is the possibility that the bond market tries to price a policy mistake in the US .”

Eurodollar futures pricing suggests traders expect at least three Fed rate hikes next year.

Inflation trepidation

Inflation risk is on Morgan Stanley’s radar, even as the firm recommends long dollar positions against lower-yielding currencies including the euro. 

Should inflation decelerate next year, some members of the Fed committee could argue for patience in raising rates, said David Adams, head of G-10 FX strategy in New York.

“That policy divergence narrative pivoting to a policy convergence narrative — where maybe the Fed is a bit more dovish than people were expecting, but other major central banks are starting to move towards the exit — that would be most likely negative for the dollar,” he said.

Meanwhile, Mirae Asset Global Investments money manager Malcolm Dorson sees an opportunity for dollar momentum to reverse in 2022 as US fiscal stimulus rolls off and vaccination rates taper while the rest of the world picks up.

“As global vaccination rates improve and the world begins to live with Covid-19 as an endemic, the ‘flight-to-quality’ trade should unwind, providing more tailwinds for international currencies,” Dorson said. 

The prospect of a short Omicron wave followed by a global recovery that brings a measure of dollar weakness is a possibility for Eric Stein, chief investment officer of fixed income at Eaton Vance.

Nuanced stance

All this points to tactical dollar trades in 2022 with strategists expecting the ICE US Dollar Index to climb just a tad over 1% by the fourth quarter, according to data compiled by Bloomberg. 

“It’s about modest dollar strength and more nuanced views,” said Homin Lee, a macro strategist at Lombard Odier in Hong Kong. The firm, which now holds long dollar positions across some portfolios, sees the euro weakening to 1.10 per dollar and the onshore yuan slipping to the 6.45 level by the third quarter. 

Nikko Asset Management shares a similar view to Lombard. 

“The main driver for the dollar will be higher interest rates, but the issue is that a lot of it is already baked into markets,” said John Vail, the firm’s chief global strategist in Tokyo. “There’s dollar strength ahead, but don’t expect it to be spectacular.” 

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