US Dollar Q3 2022 Forecast: Dollar's Run Relies On Rates, Recession And Risk

(MENAFN- DailyFX)

The Dollar performed exceptionally well through the first half of 2022 – and more broadly over the preceding year. The fundamental stars aligned between a leading Fed tightening regime, perceptions of a greater cushion for the US economy amid forecasts of a global slowdown and the reliability of the currency's renowned safe haven status. All of these elements are still in play heading into the second half of the year, but the relative potential has deflated. The underwhelming follows through for the Greenback despite the Fed's 75 basis point hike in June or during the S&P 500 's steep selloff in the first half of the same month likely indicates the limitations in support of the Dollar for the different dimensions. Can the benchmark currency extend its incredible rally into territory not charted in two decades or is it finding a peak?

In the past six months, the topic of inflation moved from scholarly debates among economists to mainstream fears over the country's ability to absorb price growth that hasn't been seen in four decades. Through the period, the Fed moved from confidence that inflation was 'transitory' to a hasty fight to head off the troublingly stubborn climb. The central bank started with a 25-basis point (bp) rate hike in March which it escalated to 50 bp at the next meeting in May and then a hefty 75 bp increase (the biggest in decades) at the June gathering. That is an aggressive policy move with swaps pricing in a resting point for the benchmark rate at 3.59 percent by year's end with a range of 1.50 – 1.75 percent heading into the second quarter. That is extraordinary in historical terms; and in a vacuum, that could perhaps keep the Dollar a steady bullish trajectory.

Yet, exchange rates are not a vacuum. Rather they are determined on a relative basis. Though the Fed earned significant premium initially to the hard steer against inflation this year, many of its other major counterparts are catching up – or have already surpassed the outlook for the US. The RBNZ and RBA forecasts see their rates ending the year above the Fed Funds average rate, while the BOC and BOE are fairly close. That said, it is the ECB's policies that most interest me for Dollar influence. While the ECB has been one of the most dovish central banks over the past decade, it has signalled capitulation to the fight inflation itself. As the European group (the second largest) moves up its forecast, it can materially dampen the perceived value to the Dollar via EURUSD .

Created by John Kicklighter

Interest rates only matter as far as the markets are healthy enough to chase the higher returns. In the environment where fear prevails, it takes far more promise of income to dampen the threat that significant losses will result from maintaining exceptional exposure in the markets. There are a number of ways to measure risk, but the traditional macroeconomic outlet is through economic activity. At the IMF's spring economic forecasts (referred to as the 'WEO'), there was a global downgrade in forecasts, but the US received a smaller reduction than most counterparts.

The drums of economic retrenchment are growing louder and louder heading into the second half of the year, but the first vestiges of the contraction were not yet showing in official data. Instead, the signals were coming from sentiment surveys (e.g., consumer, business, CEOs, etc) as well as certain market measures (e.g., the 2-10 US Treasury yield spread). With the sense of impending impact, there is a diffusion of risk when it comes to relative disadvantage. In other words, the fears are not related to one economy or another, it simply weighs the global perception of risk collectively. As we start to see official readings of economic contraction that may lead into outright recession, we will see the relative status come into play. And, given the US and Dollar are already afforded some perception of resilience, there is more to lose than gain moving forward.

Source: Google Trends; Prepared by John Kicklighter

As inflation persists, financial accommodation retracts, the economy slows, we will see the capital markets grow increasingly unsettled. In moderate levels of risk aversion, there remains an appetite to look for relative safety and return. That nuance may present a country/currency with a comparable economic trajectory as the US but a greater rate of return, and direct capital towards away from the Greenback. However, the more intense risk aversion grows, the smaller the field of relevant safe havens becomes. At the more extreme end of the risk curve (risk aversion), the Dollar and US Treasuries / Money Markets are classified in the 'last resort' category. When the most important decision is liquidity and ability to stabilize capital holdings, the Dollar historically reverts to its frequently referenced haven status.

Created by John Kicklighter

Notably, though the US equity markets fell into bear markets through the first half of 2022, there wasn't a sense of panic in the move. I am looking to measures like the VIX driving up to 50 – 70 or prime market yield spreads surging as indications that this degree of fear is entering the system. It's worth pointing out that such intense measures of fear are destructive, but they are also shorter-lived periods.

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