Beware the U.S. Dollar Rebound

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The Dollar will rebound in the first half of 2023 but strength is unlikely to exceed the highs scaled in September 2022 according to a new currency market analysis, conducted by Capital Economics.

The independent research provider and consultancy anticipates a souring in global risk appetite associated with recession in developed markets over the coming weeks and months, which will boost appetite for the Dollar over the short term.

The call comes amidst a spell of Dollar weakness that has seen it retreat against most major currencies.

Over the past month it has fallen against all its G10 peers, save for Norway's Krone.

This weakness has coincided with a rally in the Pound to Dollar exchange rate (GBP/USD) above 1.20 and highs at 1.2448 being tested in mid-December and again on January 23.

A more assertive rebound in the Dollar would put GBP/USD on notice for another dip below 1.20, but Capital Economics analyst Jonathan Petersen says the Dollar won't test or break its 2022 highs.

As such a deep dive into the early 1.10s looks remote.

"With inflationary pressures easing and the global growth outlook improving, we no longer expect the US dollar to breach its late September peak," says Petersen in a note.

Limiting Dollar strength is two key drivers of 2022 outperformance that are now acting as headwinds, these include the Federal Reserve's willingness to raise interest rates faster and further than other central banks.

"Relative monetary policy and risk sentiment have shifted from tailwinds to headwinds for the dollar," says Petersen.

Another driver of Dollar strength was dour market sentiment created by rapidly rising U.S. interest rates, a global economic slowdown related to the war in Ukraine, surging gas prices, and China's growth-sapping zero-Covid policy.

Gas prices have fallen sharply, the Fed is nearing its final destination on interest rates and China has abandoned zero-Covid.

Above: GBP/USD has recovered but is tipped to pullback as the USD rebounds. But September's nadir won't be troubled suggests new research. Consider setting a free FX rate alert here to better time your payment requirements.

What would drive the Dollar's short-term rebound, then?

"We still think that souring risk appetite associated with recessions in developed markets will boost the dollar over the short term," says Petersen.

A number of economists we follow anticipate an 'earnings recession' in 2023 as corporates reveal lacklustre performance, which in turn prompts a rerating of stock market valuations.

"We suspect optimism about the global economy is overdone and think the onset of recession in the US and other developed markets will cause a renewed fall in “risky” assets," he adds.

Furthermore, Capital Economics thinks the relative monetary policy trade now appears to be largely discounted, i.e. how much further can the Bank of England, European Central Bank et al. out hike the Federal Reserve?

Positioning is meanwhile more balanced with net speculative positioning having fallen back from extreme levels.

"On balance, while we still think there will be a dollar rebound in the first half of the year, we don’t think the greenback will exceed its prior cyclical high," says Petersen.

The Dollar has been the key driver of GBP/USD exchange rate movement of late any material rebound in the Greenback could therefore pose downside risks if it materialises.