US dollar 2023 outlook: Will inflation continue to drive the greenback lower?

Dollar suffers Q4 setback after year of gains

The dollar has been the perhaps the most significant mover of 2022, with the wider implications of this appreciation serving to shine a light on the greenback. While the dollar has been the poster child of this period, traders across the board will need to pay close attention on the greenback as significant correlations bring the potential to drive moves elsewhere. First let’s look at the relationship between the US dollar and 10-year treasury yield. This highlights a very clear correlation between the two markets over the course of this crisis. That has not always been the case, with the two often taking on a negative relationship. Notably, the 2007 and 2020 crises both brought about a major divergence as yields decline and the dollar heads higher. This time around we are seeing higher yields as central banks push up interest rates rather than the usual monetary loosening in the face of economic hardship. With that in mind, traders should keep a close eye out for the trajectory of the US 10-year treasury yields, with further downside likely to drag the dollar lower. Essentially, we are seeing yields reflect the perception of Federal Reserve interest rates going forward. Should we see any major hiccups that would drive fears of a secondary rise in CPI, that would likely push yields and the dollar higher.

Sticking with treasuries, it is interesting taking a look at the yield curve for US treasuries, with the inversion between short and long-term bonds signalling an expectation that we will see the FOMC cut the Feds Fund rate down the line. The timing of that will be crucial, with such a loosening phase likely to bring significant dollar weakness to reverse the 2022 outperformance. The chart below highlights how recent inflation data has served to drive down medium and long-term dated treasury yields, with further downside in CPI likely to do the same to the detriment of the dollar. As such, keep a close eye out for inflation data given how it impacts forward-looking interest rate expectations, and thus market sentiment.

Inflation will remain the key data-point to follow over the course of 2023, with the success or failure in keeping that figure on a downward trajectory bringing huge implications for market sentiment. The chart below highlights how markets are largely factoring in a steady decline in inflation over the course of the coming years, with 2023 expected to end with a CPI figure of 3%. While that remains above the 2% target, such a collapse in inflation would likely bring upside for equities and a decline in the dollar. We can see that below, with the dollar topping out after inflation took a downwards turn. The big question traders need to ask themselves is whether such a clearcut downward trajectory for inflation is likely to occur. If the answer is yes, then we will likely see the dollar lose ground over the course of 2023. However, should we see any major bump in the road, we could see equities suffer and the dollar back on the front-foot.

What does a bump in the road look like for inflation?

The trajectory of inflation will typically normalize towards zero over time given the base effects that come in to smooth out any dramatic short-term rise in prices. That brings hope that we will ultimately see inflation return back towards target in time. However, it is worthwhile noting the potential for another spike in the more volatile elements in the CPI reading. The most obvious would be energy, with the Russia-Ukraine conflict continuing to limit supplies to Europe. While it appears to be the case that European gas stockpiles are plentiful this winter, the lack of any Russian gas imports and resurgence Chinese demand could make things tough next year. Meanwhile, OPEC+ are doing their best to drive up prices, with the Saudi Energy Minister recently signalling their willingness to cut further if needed. With OPEC limiting production, Biden likely to ease their SPR releases, and the Chinese economy expected to emerge after lockdown restrictions, there certainly is a possibility that crude pushes higher in 2023. Such a move would raise input prices for businesses and lift the cost of goods/commodities. As such, keep a close eye out for a potential resurgence in energy prices, with such a move bringing potential upwards revisions to inflation expectations. Should that occur, we could be in for another risk-off phase that benefits the dollar. The chart below highlights just how volatile energy has been compared with many of the other elements that make up the CPI reading. In fact, year-on-year energy inflation topped out in June at a whopping 41%. Keeping a lid on energy prices will be key in limiting another uptick in inflation.

What about growth data?

Growth concerns should also be factored in given the role of the dollar as a haven at times of heightened risk. To some extent the expectations of an economic collapse in 2023 should lessen the market reaction when it does take shape. However, the depth and length of that period will undoubtedly be key elements that markets attempt to adjust for. The chart below looks at how the dollar is highly correlated with key growth indicators such as the PMI figures. While GDP shows a similar picture, it is typically a highly lagging indicator. As such, we can see how a reversal in the trajectory of the services and manufacturing PMI figures could drive further dollar weakness for the dollar. Similarly, a major collapse in growth could provide near-term haven demand for the dollar. From a monetary policy perspective, any improvement in the growth outlook allows the central bank to maintain elevated rates with a view to drive down inflation. Meanwhile, a collapse in growth puts pressure on the Fed to cut rates before inflation has come down towards target range. As such, the reaction to weakening data will not always be clear-cut in 2023, as traders weigh up the dollars haven role, and monetary policy implications.

Dollar index technical analysis

The dollar has been hit hard over recent months, with that collapse from the September high signalled on the monthly chart below. Interestingly, we have subsequently slumped back into the key 103.62 support level, with price holding up at that historically important level for now. This wider timeframe highlights how momentum has shifted to bring the stochastic oscillator back below the 103.80 support level. Meanwhile, the MACD histogram has been heading lower to reflect the apparently impending bearish crossover. This could bring about a protracted move lower should inflation continue its downward trajectory.