• Previously we expected the dollar to be supported by a high and rising safe-haven premium in an environment of high inflation, a major geopolitical shock to energy markets and increasing chances of economic recession. Since we last wrote the dollar has continued to strengthen.

• Over recent weeks, European energy prices have begun to fall. We consider how to balance this necessary condition for a peak in the dollar against the ongoing risks to global growth and the persistence of high inflation.

• Our quantitative indicators continue to signal the dollar is overvalued. We believe that the prospects for valuation based strategies are becoming more attractive for investors with a sufficiently long time horizon.

Since our last publication, the dollar has continued to strengthen. In inflation adjusted terms, the trade weighted dollar has now appreciated over 10% this year, helping to tighten US financial conditions and reduce the inflationary pressure from imported goods.

Exhibit 1: US dollar real effective exchange rate around multi-decade highs

Source: Bloomberg, JPMAM. As at October 2022

We have previously highlighted the importance of high natural gas prices for Europe’s terms of trade. Over the last few weeks, European gas prices have accelerated their recent decline to trade at around a third of the highs seen in August. Prices still remain elevated in comparison to multi-year averages and energy import costs will continue to offset the majority of Europe’s surplus on manufactured goods, even at current levels. Geopolitical risks to energy markets show no signs of abating, with the Nordstream pipeline damage highlighting infrastructure vulnerabilities alongside OPEC supply cuts. With winter approaching, the prospect of colder than typical weather may yet see the recent falls in gas prices reverse.

We have spent much of the year regarding energy costs as the most import factor for currency markets, but our view is now evolving considering recent developments. When balancing the effect of high but falling energy prices on currencies we regard the situation as more neutral, raising the possibility of a modest recovery in the euro. 

Exhibit 2: TTF European natural gas prices have begun to fall 

EUR/MWh, Source: Bloomberg. As at October 2022

Heightened recessionary fears remain on investors’ minds, with the Federal Reserve (the Fed) continuing to welcome tighter financial conditions as it seeks to prevent high inflation becoming entrenched. We expect Fed policy to continue to support the dollar via two channels.

Firstly, with US rates above other major global currencies, the carry favours the US dollar. While carry has not been a reliable guide to currency returns for the last decade, we do recognise that current hedging costs, and the liquidity requirements associated with currency hedging, are becoming more challenging for global investors in US assets.

Secondly, the dollar remains the most prominent safe haven asset globally. Over 2022, government bonds have not acted an effective hedge for equity holdings and the yen has weakened to levels against the dollar not seen since the 90s due to the Bank of Japan’s dovish monetary stance. This implicit safe-haven premium should continue to be dollar supportive until US inflation begins to fall.

When balancing the reversal in energy prices with the ongoing support from a hawkish Fed, we see scope for a modest recovery in EURUSD in the short term but the extent of any gains are likely to be limited until US inflation peaks.

Exhibit 3: Safe haven assets correlation with equities by inflation regime since 1980

Source: JPMAM, Bloomberg. As at October 2022

Taking a longer term perspective, our quantitative valuation framework continues to identify the dollar as overvalued. This is based on both purchasing power modelling and the US balance of payments weakness. Valuation based approaches to currency investing have a long and successful track record but are prone to significant drawdowns as a result of the long cycles observed in currency markets.

We do not expect to see a significant reversal in dollar valuations until the rate of inflation begins to converge to the Fed’s target and European energy prices fall further. However, on a multi-year horizon we are confident that the gap between energy costs in the US and Europe will narrow upon completion of current infrastructure investment projects, even without the resumption of Russian energy exports. Sole reliance on the US dollar as the pre-eminent safe haven should also reduce as we expect bonds to regain their negative correlation to equities over time.

While current fundamentals are undoubtably challenging, we note the extreme level of our quantitative valuation measures and negative shorter term market technicals for the dollar. We therefore see scope for clients with a long time horizon to find opportunities in valuation driven currency strategies.