Investing.com – With the U.S. Federal Reserve approaching a major turning point in its monetary policy tightening cycle, pressure on the currency could soon peak.
Analysts at Barclays point out that while further weakness in the dollar is possible, the worst of its decline may be over.
The evolving outlook for US monetary policy, coupled with global economic conditions, points to the dollar remaining more stable in the coming months, even as the Fed begins its rate-cutting cycle.
Over the past few months, market participants have increasingly priced in the likelihood of earlier and faster rate cuts by the Federal Reserve. These expectations have been driven by perceptions of a slowing US economy and the Fed’s accommodative shifts.
Real final interest rates, which reflect where the market expects the Fed’s tightening cycle to end, have fallen from about 200 basis points earlier in the summer to below 50 basis points in recent weeks.
Despite this downward shift in interest rate expectations, Barclays analysts believe that most of the decline in the value of the dollar has already occurred.
The dollar index, which tracks the greenback’s performance against a basket of major currencies, has been declining since mid-2023. However, the pace of further declines is expected to slow as the Federal Reserve’s monetary policy tightening cycle nears its end.
“However, the bulk of dollar weakness tends to occur ahead of Fed easing cycles, and this move was already massive by historical standards,” the analysts said.
The dollar typically hits its lows shortly after the first cut as the market begins to reassess economic expectations. This pattern repeats itself again, with the market already pricing in future cuts, causing the dollar to weaken accordingly.
But as the rate-cutting cycle progresses, the market often corrects its expectations about the depth of the cuts. If the U.S. economy manages to avoid a deep recession, the Fed may cut rates more cautiously than expected, which could lead to a steady or even rebounding dollar.
In milder economic downturns, the dollar tends to recover once the market realizes that the Fed is not cutting interest rates as aggressively as feared.
Barclays Bank says there are several factors likely to limit further dollar declines, including the possibility of a recession in the United States.
If the economy enters a recession, the dollar may rise, as investors typically seek safety in U.S. assets during times of global uncertainty.
In this risk-averse environment, the dollar’s safe-haven status may come into play again, especially against emerging market currencies.
Moreover, geopolitical factors, including ongoing tensions in Europe and China, could provide support to the dollar.
Barclays noted that risks related to US-China trade relations and concerns about political stability in Europe could prevent the dollar from weakening further.
The upcoming US presidential election also raises the possibility of shifts in trade policy, which could introduce new volatility into global markets, indirectly supporting the dollar.
Another major factor is the slowdown in China’s economy. With growth in China continuing to falter, due to weak credit momentum and weak consumption, the outlook for China remains bleak.
A weaker yuan could provide additional support to the dollar, especially against Asian and emerging market currencies. Barclays notes that weaker credit impulses in China tend to correlate with a stronger dollar.
Barclays expects the US dollar to fall further in the near term, as the market continues to price in interest rate cuts from the Federal Reserve.
However, they expect the extent of further weakness to be modest, with the bulk of the dollar’s decline already behind it.
As the Fed’s rate-cutting cycle progresses, the dollar may begin to recover, especially if economic data points to a more moderate slowdown than expected.
“Our new forecasts suggest further depreciation of the US dollar through Q4 2024, but a recovery thereafter,” the analysts said.
This recovery may be driven by a recalibration of market expectations for a rate cut by the Federal Reserve, coupled with an improvement in global risk sentiment.
Barclays notes that while bouts of volatility are still possible, the broad downtrend in the dollar may be coming to an end.