The prevailing market consensus points toward lower interest rates in developed countries next year, with both the Federal Reserve (Fed) and the European Central Bank (ECB) anticipated to make rate cuts.
However, the economic divergence between the US and Europe suggests a potentially more aggressive stance from the ECB. While traders are pricing in around three rate cuts from both central banks in the first half of the year, the contrasting economic conditions paint a different picture.
"A slowing global economy, easing inflation pressures, and cooling labor markets would open the door for rate cuts from major central banks next year," said Dean Turner, chief eurozone and UK Economist at UBS Global Wealth Management
A Volatile 2023 Year
At the end of 2022, FX strategists were mostly discussing fewer trends and more volatility in their outlook for this year. In reality, the first half of the year lacked clear trends, while the second half witnessed a powerful and orderly surge in the US dollar.
This dollar rally was underpinned by the exceptional performance of the US economy, boasting an impressive quarter-on-quarter annualized growth rate of 4.9% in Q3.
Despite a dip in headline inflation, the Federal Reserve has maintained a hawkish stance due to insufficient evidence for a shift.
Consequently, holding dollars emerged as a seemingly straightforward trade, reflecting investors' response to global slowing aggregate demand, particularly affecting the more open economies and currencies of Europe and Asia.
However, the dollar fell sharply in October after the Fed hinted it is likely done raising rates. The dovish pivot was reaffirmed at the December meeting, which sparked another robust rally in risk assets.
As such, investor focus shifted toward cuts, which allowed yields to fall dramatically, pushing the dollar lower as well and allowing stocks to stage a massive rally. The euro has gained more than 5% versus the greenback in the final three months of 2023.
“Will this theme continue into 2024? It feels like a wrestling match and the dollar will not roll over that easily,” Chris Turner, Global Head of Markets and Regional Head of Research for UK & CEE at ING, said.
“Yet our simple thesis is that tighter interest rates finally catch up with the US economy next year, growth registers a paltry 0.5% and the Fed, in line with its dual mandate to focus on inflation and maximum employment, cuts rates back into less restrictive territory.”
This view is based on the end of US exceptionalism, which, according to Turner, will allow “greater diversification amongst the investor community and a lower bar to seek returns outside of the dollar.”
“Our baseline view for 2024 sees the dollar bear trend picking up pace through the year. Compared to year-end 2024 forwards, currencies could be as little as 2% (China’s renminbi) to as much as 13% (Scandinavian FX) firmer against the dollar.”
EUR/USD is looking to close the 2023 year around 1.11, which would represent a rise of about 4% year-to-date.
Markets May Be In For a Surprise
Europe, as indicated by PMI data, is experiencing contraction and deceleration, while the US is witnessing expansion despite slowing inflation. This suggests that the Fed has the flexibility to cut rates at its discretion, waiting to ensure effective inflation control. In contrast, the ECB might need to adopt a more accommodative stance to prevent economic stagnation, potentially leading to rate cuts in late Q1.
What does this mean for the dollar? As markets priced in as many as seven rate cuts next year, compared to the Fed’s current expectations for three, the risk for the USD is skewed to the downside. Many FX strategists expect the greenback to finally break below 1.10 against the euro.
“We expect EUR/USD to trade at lower levels on a 6-12M horizon based on relative terms of trade, real rates (growth prospects), and relative unit labor costs,” Danske Bank strategists said earlier this month.
However, the outcome in which ECB adopts a more accommodative stance could prompt a strengthening of the US dollar in the coming months, impacting various asset classes. Gold and emerging market assets may face headwinds, while the lower-rate environment could continue to support US stocks.
At the moment, the market seems divided on whether the Fed will start cutting rates in Q1 or Q2. As was the case in the last 2 years, the central bank is likely to maintain its data-dependent approach with a firm focus on the health of the economy and consumers, as inflation continues to head lower (at least this is the consensus).
“We still expect the first cut in March, followed by quarterly 25bp reductions through 2024-2025. First cut 9 months after the final hike would be well in line with historical standards,” Danske Bank strategists also said.
Summary
The overwhelming consensus at the moment calls for rates to head lower next year, allowing for a prolonged rally in stocks and a fall in yields and the dollar. However, the dollar strength could catch markets off guard as other central banks could be forced to adopt a more accommodative approach.
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Shane Neagle is the EIC of The Tokenist. Check out The Tokenist’s free newsletter, Five Minute Finance, for weekly analysis of the biggest trends in finance and technology.
