Dollar on pace for first yearly loss since 2020

By Karen Brettell and Samuel Indyk

NEW YORK/LONDON (Reuters) – The dollar is set to end 2023 with its first loss since 2020 against the euro and a basket of currencies on expectations the U.S. Federal Reserve will begin cutting rates next year as inflation moderates.

Questions for 2024 will be when the Fed begins cuts, and whether the first rate reduction is made to avoid over-tightening as inflation drops, or due to rapidly slowing U.S. economic growth.

With markets already pricing in aggressive cuts, debate is also focused on how much further the dollar is likely to fall.

“We’ve already weakened quite a bit in anticipation of a Fed cut cycle to come,” said Brad Bechtel, global head of FX at Jefferies in New York.

The dollar’s decline accelerated after the Fed adopted an unexpectedly dovish tone and forecast 75 basis points in rate reductions for 2024 at its December policy meeting.

Markets are pricing in even more aggressive cuts, with the first reduction seen likely in March and 154 basis points in cuts expected by year-end.

The Fed’s tone contrasted other major central banks, including the European Central Bank (ECB) and Bank of England (BoE), which maintained they will hold rates higher for longer.

But “I do think they will capitulate. European growth is just struggling too much and inflation’s coming down relatively fast… same in the U.K. in many ways,” said Bechtel. “If all three central banks are cutting, it’s going to be very hard for the dollar to weaken significantly.”

Against a basket of currencies, the greenback was little changed on Friday at 101.18, rising from a five-month trough of 100.61 reached on Thursday. It is on track to lose 2.23% this year.

The euro gained 0.07% to $1.1069, hovering just below a five-month peak of $1.11395 reached on Thursday. It is heading for a 3.31% gain for the year, its first positive year since 2020.

“Markets are looking for a cut earlier in the U.S. and are less certain that the European Central Bank will cut as quickly, so that’s why the dollar is very soft,” said Niels Christensen, chief analyst at Nordea.

“We also have positive risk appetite which is another negative for the dollar. Going into 2024, the soft dollar will be a theme towards the March central bank meetings,” Christensen added.

Policymakers at the ECB and the BoE did not signal any imminent rate cuts at their policy meetings this month, but traders are pricing in 161 bps of cuts by the ECB next year, with the probability of two cuts by April. The BofE is also expected to cut rates by 148 bps in 2024.

“While it feels like the market might have moved too far too fast, the facts are that growth is non-existent in Europe, slowing in the U.S., and inflation is falling globally,” said CJ Cowan, portfolio manager at Quilter Investors.

“The ECB is famously slow to change policy course so almost two cuts priced by April looks aggressive, even if it might be the right thing to do.”

Sterling was little changed on the day at $1.2733 and on track for a 5.29% yearly gain, its best performance since 2017.

YEN IS AN OUTLIER

The dollar is expected to post at 7.91% gain against the yen as the Japanese currency stays under pressure from the Bank of Japan’s (BOJ) ultra-loose monetary policy stance.

Market expectations are for the BOJ to exit negative interest rates in 2024, though the central bank continues to stand by its dovish line and has provided little clues on if, and how, such a scenario could play out.

“The outlook for Japan is encouraging going into 2024, with expectations of robust economic growth and improving inflation that shows signs of being sustainable,” said Aadish Kumar, international economist at T. Rowe Price.

That said, even if the BOJ hikes rates into positive territory, they will still remain much lower than in the United States.

“For all of 2024, if they got to positive 50 basis points I would be kind of surprised, but maybe that happens, and if the Fed gives us three rate cuts, you’re still looking at an interest rate differential of roughly 4.5% or so, which makes the yen very expensive to own,” said Jefferies’ Bechtel.

The yen is a popular funding currency, and investors use proceeds from shorting the yen to purchase other assets.

rose 0.8% to $42,922. It is on track for a 159% gain this year.

========================================================

Currency bid prices at 10:00AM (1500 GMT)

Description RIC Last U.S. Close Pct Change YTD Pct High Bid Low Bid

Previous Change

Session

Dollar index 101.1800 101.2000 -0.01% -2.232% +101.4200 +101.0900

Euro/Dollar $1.1069 $1.1062 +0.07% +3.31% +$1.1084 +$1.1044

Dollar/Yen 141.4700 141.4050 +0.05% +7.91% +141.9100 +141.1500

Euro/Yen 156.61 156.43 +0.12% +11.63% +156.9200 +156.2800

Dollar/Swiss 0.8378 0.8448 -0.82% -9.39% +0.8446 +0.8357