Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.
3 March 2023
Solving the dollar dilemma
After declining significantly in the fourth quarter of 2022 and January 2023, the US dollar has staged a comeback in February. We assess if this is the start of a new trend or whether the dollar is set to resume its decline.
Fundamentals
After the Russian invasion of Ukraine in early 2022, investors flocked to buy US dollars for two primary reasons. Firstly, the currency serves as a safe haven investment in times of uncertainty. Secondly, the increase in US shale production in recent years has allowed the US to become energy independent, thereby leaving it less exposed to volatile global gas markets. The US even started to export this gas and profit from sending surplus energy abroad, particularly to Europe, at higher prices. However, we have seen a reversal of these factors in recent months. Central banks have hiked policy rates considerably, yet somehow have managed to keep the possibility of a soft landing alive, which has supported investor confidence and reduced the need for a safe haven. Meanwhile energy prices have declined significantly from their peaks in the summer of 2022 and stayed low throughout a warmer than expected winter in Europe. As these fundamental factors which drove the US dollar in 2022 wane, the dollar should revert back to previous levels.
Quantitative valuations
The dollar has been on a bumpy ride over the past six months and moves versus the euro can be used as a reflection of this journey. The euro depreciated versus the dollar to a cycle low of 0.96 at the end of September 2022 (conversely, this can be thought of the dollar appreciating to a level versus the euro not seen since 2002). Following this overshoot, the euro sharply appreciated to 1.10 by early February 2023, an increase of approximately 15% in just five months. As support for the dollar started to abate, the currency subsequently declined but the change in price went too far, too quickly in this regard. As a result, the euro depreciated back down to 1.06 during February, a fall of 3.6%. Despite the developments since early Q2 2022, the dollar remains overvalued when compared to longer-term fair valuation measures such as real effective exchange rate and evidence of this overvaluation is still prevalent even after adjustments are made for energy independence. We therefore find that February’s dollar bounce has provided an attractive entry level into renewed short positions, particularly against the euro and selective emerging market currencies with strong fundamentals and carry such as the Brazilian real and Mexican peso.
The dollar remains overvalued, providing an attractive entry point for short positions
Source: Bloomberg, J.P. Morgan Asset Management, data as of February 2023. REER – Real Effective Exchange Rate.
Technicals
The appreciation of the dollar in February was largely driven by technical considerations as investor sentiment grew too extreme regarding the dollar decline and market positioning became stretched. This excessive positioning has since been reduced, with two-way risk now priced in. In addition, as inflation continues to decline, we expect a return to more normal equity-bond correlations, which will decrease the need for investors to use the dollar as the primary safe haven in portfolios and instead move towards higher yielding fixed income investments. Also, flows within equity markets tentatively suggest that US investors are increasing their investments into European equities. Conversely, European investors are decreasing their investments into US equities. Similarly to fixed income, this would suggest less support for the dollar.
What does this mean for fixed income investors?
While dollar overvaluation may not be as extreme as six months ago, we find that there is still reason to expect the dollar to decline over the medium-term. The driver of future dollar declines, however, has shifted from being based on significant overvaluation to being more dependent on technical elements such as the continued rotation from US equities to non-US markets and bonds. If this does occur, the path of dollar depreciation will be slower and choppier in nature. It is important that investors understand the inherent impact to both return and risk from foreign currency exposures within their portfolios and consider implementing processes to effectively manage currency risk.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations
is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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