FX.co ★ Will the U.S. dollar dominate in 2023?

The US dollar was one of the winning trades of 2022, peaking in September at a 20-year high, gaining about 20% against a basket of currencies. But will it dominate next year amid a slower interest rate cycle, recession fears and other external factors such as China's reopening?

The current year for the U.S. dollar began with bullish sentiment, which intensified when the Federal Reserve began an aggressive tightening cycle in March. Since then, the Fed has raised a total of 425 basis points, bringing the federal funds rate to a range of 4.25–4.5%.

The Fed has been one of the main drivers of the U.S. dollar. On top of that, the poor stock market performance prompted many investors to use the dollar as a safe-haven currency.

Since the beginning of the year, the U.S. Dollar Index (DXY) has risen to a near 20-year high above 114 in September.

Looking to 2023, the Fed remains hawkish despite a slightly smaller 50 basis point increase this month compared to a 75 basis point increase in the previous four meetings.

At the December press conference, Fed Chairman Jerome Powell said: "We've raised 425 basis points this year, and we're into restrictive territory. It's now not so important how fast we go. It's far more important to think about what is the ultimate level. And ... how long do we remain restrictive? That will become the most important question."

The key question for the U.S. dollar next year is how long the Fed will need to maintain higher rates. According to the Fed's latest economic forecasts, the average federal funds rate forecast for next year is 5.1%, with GDP projected at 0.5% and PCE inflation slowing to 3.1% in 2023.

Strong dollar by the beginning of 2023

Many analysts see the future in USD trading early to mid next year, with central bank meetings and inflation data setting the tone for 2023.

"FX markets are assuming that central banks can signal the all-clear on inflation and deliver gentle easing cycles to ensure soft landings in 2023. We suspect the reality will not be quite as kind to financial markets," said ING's FX strategists Chris Turner and Francesco Pesole. "We back a stronger dollar into early 2023."

Wells Fargo views 2023 as the dollar's "last hurrah" before the start of a bearish trend.

"The greenback can experience a bout of renewed strength into early 2023. With the Fed likely to deliver more hikes than markets are priced for, a hawkish Fed should support the greenback," said Wells Fargo 2023 Outlook. "We believe the Fed is likely to deliver more interest rate hikes than financial markets are priced for, and indeed more tightening than many other central banks."

However, by the middle of next year, the outlook is changing as the U.S. economy begins to slow down, putting pressure on the dollar.

"Starting in the middle of next year, we believe growth differentials between the United States and major foreign economies should start to favor international G10 countries, and these growth dynamics should be a contributing force to a sustained dollar depreciation," Wells Fargo said. "We expect the United States to enter recession only during the second half of next year."