Dollar's Revenge: 3-4% Recovery Possible says BMO Capital

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The Dollar's sharp fall over the course of the past week is looking overdone, according to an analysis from BMO Capital Markets.

In a new research briefing, analysts at the investment banking arm of Bank of Montreal say "the magnitude of the USD decline exceeds the adjustments in other markets, so we doubt it can hold."

The findings offer a word of caution to those watching the Dollar for an opportunity to buy at more competitive rates following the currency's historic rally.

But a softer-than-expected decline in U.S. inflation triggered the Dollar index - a measure of broader U.S. Dollar performance - into a nearly-4.0% decline last week, making it the largest one-week decline in a decade.

Further losses of 0.40% this week have allowed the Pound-Dollar and Euro-Dollar exchange rates to recover to multi-week highs.

But Greg Anderson, Director and Global Head of FX Strategy at BMO Capital Markets, says the Dollar will retrace a good portion of recent declines.

"Expect the USD to rally roughly 3% on a 1M horizon and about 4% through the year's end," says Anderson in a regular research briefing.

"We expect USD strength to continue through Q1 of next year, before giving way to gradual USD weakness as risk appetite builds and the Fed sits on hold," he adds.

The softening of headline CPI inflation in October prompted a significant market rally as investors bet the Federal Reserve would be in a position to consider ending its interest rate hiking cycle. A peak-inflation theme has translated into a peak-Dollar trade as investors switched out of cash and into higher-yielding assets.

The Dollar extended losses on Tuesday after another measure of U.S. prices - PPI inflation - also surprised to the downside.

But there was no discernible follow-through to this data reading, suggesting the peak-inflation trade could be fading.

"Despite the broad US dollar being very expensive already, we think the probability of it rallying 10% is greater than the probability of it declining 10%, but we think the most likely 2023 outcome is that it dies off into a range," says Anderson.

Some key findings of BMO Capital's research into the Dollar include:

• Expect a number of rough patches for global markets over the next six months
• Long list of worries include: end to Fed and other major central bank rate hikes, improved growth data, further improvement in the pandemic situation, some type of stabilization of the Ukraine War
• Fed's broad real trade-weighted dollar was 22% above its average for the post-Bretton Woods period (1973 onward) as of the October reading
• This suggests that the USD is extremely expensive
• Expensive currency is typically a worry for an economy
• But the U.S.'s external position has actually improved in 2022
• Meaning overvaluation can continue for some time

Above: the USD index, image courtesy of The Technical Trader.

Although the Dollar might prove resilient over the next three months, it is not clear that it will register fresh highs again.

"Dollar bulls are feeling the squeeze," says Kit Juckes, Chief FX Strategist at Société Générale. "While there are still some nasty tail risks out there, we are in the process of seeing inflation peak".

"Fed rate hikes are priced in, the high has been for bond yields; the Chinese authorities will support the housing sector and slowly reopen the economy; emerging markets are turning a corner and offer attractive entry levels in currencies and bonds. And so on..." he adds.

The U.S. Dollar Index posted a multi-year peak of 114.1 near the end of September, "and although its price action became somewhat choppy after that there was still little in the chart outlook to suggest that it was on the verge of a major reversal," says Bill McNamara, analyst at The Technical Trader.

"However, that’s what we got last week as the U.S. currency slumped on the back of the inflation data: it closed with a loss of 3.8%, and that was its largest weekly drop since March 2020... it's hard to imagine that this doesn't mark the end of the rally," says McNamara.

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