Investors typically assess the strength of the U.S. dollar (USD) through a Federal Reserve-centric lens. The dollar’s exceptional strength against a broad basket of currencies has clearly benefited from seven rate hikes last year that took the Fed’s target federal funds rate to its highest level in 15 years. As the Fed continues its fight to bring down inflation in the U.S., we expect it will hike rates again at its next meeting on 1 February, and again in the first quarter of 2023, before pausing.

While higher yields clearly worked in the dollar’s favor last year, any forward-looking view must also take into account how the dollar was buoyed by the shocks of 2022 – the Russia-Ukraine war, the spike in energy prices, and inflation – and the extent to which they may abate in 2023.

PIMCO believes the dollar, which has depreciated since hitting a 20-year peak last September, is likely to fall further in 2023 as inflation falls, recession risks decline, and other shocks abate.

Risk aversion drove USD strength

In addition to higher interest rates and yields in the U.S., the USD gained support from risk-aversion across two vectors.

First, monetary policy has been much more volatile than normal and highly correlated across developed market countries. Since March 2022, policy has tightened sharply almost everywhere (except China, where financial conditions tightened via other channels). Accordingly, volatility rose in markets for fixed income, foreign exchange (FX) and equities. The USD – widely viewed as a safe haven – benefited.

Second, while we have tended to describe USD strength chiefly as a reflection of U.S. economic policies, in our view it is more likely the sum of fears elsewhere – or more specifically, major shocks that hurt growth in key regions. These include:

• A substantial risk premium imposed on European assets last year for the tail risk that Russian energy supplies could be severed – or worse, a nuclear event
• The Russia-Ukraine war amounted to a global shock in terms of trade for energy. Importers in Asia and Europe suffered from higher energy prices while exporters such as the U.S. reaped the gains.
• And then there was Beijing’s zero-COVID policy, which created a negative demand shock for China and the region.

USD weakness ahead

Over the coming months, though, we believe the dollar’s yield advantage versus other developed economies will narrow as the Fed moves toward an expected pause in its hiking cycle in 1Q 2023. Given the faster pace of cumulative rate hikes on the way up, the USD’s yield advantage is likely to fall in the early stages of a rate-cutting cycle, even if the dollar sustains its relatively high yield.

Moreover, changes in risk perceptions about inflation and growth have tended to be inversely correlated. As inflation recedes, growth expectations tend to improve. This tends to reduce uncertainty and works against the broad strength of the USD, in our view.

Other factors that could promote USD weakness include:

• Fed policy, which tends to govern the pace of rate hikes elsewhere. A slowdown – and eventual pause – in the Fed’s rate-hiking cycle likely means other central banks slow and eventually pause.
• A reduction in uncertainty and increase in risk appetite among investors as inflation falls. Even if other central banks retain higher real interest rates, nominal rates are likely to fall globally as inflation declines.
• The end of China’s zero-COVID policy, at least to the extent it leads to a firm recovery

How the dollar’s path may unfold

In short, we believe risk premiums will decline as inflation – and monetary policy volatility decline. New shocks are clearly a risk, but the risk premium in the USD (and cross-asset volatility) remains substantial, in our view.

None of this precludes the possibility that inflation becomes stickier in the U.S. than in other advanced economies or that monetary policy remains tight for an extended period. Indeed, current levels of implied volatility in currency and fixed income markets suggest the risk premium in USD market pricing remains sizable.

However, these premiums could decline further as shocks recede and evidence builds that last year’s surge in inflation is well and truly improving and abating. We expect the USD will continue to lose its appeal as the safe-haven currency of last resort.

Learn more about PIMCO’s near-term outlook for the global economy and markets in our latest Cyclical Outlook, “Strained Markets, Strong Bonds.”

Gene Frieda is a global strategist and regular contributor to the PIMCO Blog.