The decade-long bull market in the U.S. dollar may have come to an end, but we don't anticipate a major bear market unfolding in 2023. In our view, the dollar's surge in 2022 is largely due to the rapid pace of Federal Reserve rate hikes. With the pace of Fed tightening likely to slow, the dollar has room to retreat further in early 2023 should central bank policies become more aligned.
A long bull run
The U.S. dollar advanced by nearly 50% against a broad range of currencies from its 2011 low to its recent peak in September 2022. The long-term bull market was propelled by the resilience of the U.S. economy, relatively high interest rates compared to other major countries, and safe-haven demand amid turbulence in global politics. Those factors remain intact and should help the dollar find its footing in the months ahead.
The U.S. dollar has risen sharply since 2011
Source: Bloomberg. Bloomberg Dollar Spot Index (BBDXY Index). Daily data as of 1/12/2023.
Past performance is no guarantee of future results.
Interest rate differentials
U.S. interest rates have fallen sharply in the past few months but are still high relative to those in most other major countries, thanks to the Federal Reserve's aggressive rate-hiking policy. In general, developed-market countries with higher interest rates tend to have stronger currencies because investors earn higher returns, all else being equal. Higher interest rates tend to make a currency more attractive to hold and more expensive to short,1 because the investor who is short the currency has to pay the difference in interest rates.
The dollar's recent pullback reflects a change in market expectations for the path and size of Fed rate hikes. After discounting a peak federal funds rate of 5% to 5.25%, the market is now pricing in a peak closer to 4.9% and rate cuts later in the year. Meanwhile, Europe and the U.K. are expected to continue hiking rates. Even the Bank of Japan is allowing its bond yields to rise modestly. As a result, the gap between U.S. yields and those in other major countries has fallen from about 2.4% to 1.7% based on the Bloomberg U.S. and Global ex-USD Aggregate Bond indexes.
The gap between U.S. yields and those in other major countries has narrowed
Source: Bloomberg. Bloomberg Global Aggregate Bond Index and Bloomberg US Aggregate Bond Index. Weekly data as of 1/6/2023.
Past performance is no guarantee of future results.
We anticipate some further narrowing in the yield gap in early 2023, but interest rates in the U.S. are still likely to remain higher than those in most other major developed countries even if the Fed cuts rates later in the year, limiting the dollar's downside. Moreover, there is likely more risk that the Fed exceeds expectations on the upside than the downside given its concern about strength in the U.S. labor market fueling inflation.
Demand for dollars to stay strong
In addition to capital inflows due to high interest rates, the dollar has also benefitted from strong foreign direct investment in recent years. Direct investment includes ownership in companies or real estate. According to the World Bank, the U.S. attracted the highest level of foreign direct investment of any country in 2021, the most recent period for which there is data. At nearly $5 trillion, it was the second highest on record. We expect the trend to continue as companies shift production closer to major consumers in response to global trade tensions.
Finally, demand for the dollar as a safe haven is likely to continue as a supportive factor in 2023. The ongoing war in Ukraine, trade conflicts, uncertainty about the path of the COVID virus and its impact on economic growth, and political upheaval in many parts of the world have made U.S. investments look relatively attractive over the past few years.
Bond investors' dilemma
For investors, the outlook for returns on international bonds has improved with the rise in interest rates abroad. Yields are now positive in Europe and Japan after a decade of hovering near zero or in negative territory. However, the gap in yields versus the U.S. is still relatively wide. Although the yield spread is shrinking, it would take another decline in the dollar to offset the yield advantage.
To see the impact of currency and interest rates on bond returns, we can look at the total return of the U.S. Aggregate Bond Index compared to the Global Aggregate Bond Index excluding the U.S. since 2011. During that period, an investor in the U.S. Agg would have earned a cumulative 27% return, while a U.S. dollar-based investor in the Global Agg would have had a cumulative total return of -7.0%.
The U.S. Agg has performed more strongly than the Global Agg ex-U.S.
Total returns using weekly data from 12/31/2010 through 1/6/2023. Bloomberg U.S. Aggregate Bond Index (LBUSTRUU Index) and the Bloomberg Global ex-USD Aggregate Bond Index (LG38TRUU Index). Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
Consequently, we are still cautious about the near-term prospects for investments in international developed market bonds versus U.S. bonds for dollar-based investors. Longer term, an allocation to international bonds has historically provided diversification benefits. Those days may be coming back. If the difference in interest rates between the U.S. and other major developed countries continues to diminish as the Fed reaches the end of its rate-hiking cycle, then we would turn more bullish on international bonds.
For the dollar in 2023, we look for further downside in the near term, but expect it to stabilize by mid-year. A reasonable target would be the average of the range that prevailed prior to the pandemic, or about 3% to 5% lower.
1 Short selling is a strategy that speculates that the price of a security or stock will decline. In short selling, a trader borrows shares and sells them at the market price. Before the borrowed shares must be returned, the trader hopes the price will decline and that the shares can be repurchased at a lower cost.