Fed's drag on the dollar may soon peak: Barclays

Investing.com -- As the U.S. Federal Reserve approaches a key turning point in its tightening cycle, the drag on the U.S. dollar may soon reach its peak. 

Analysts at Barclays (LON:BARC) suggest that, while further weakness in the dollar is possible, the worst of its depreciation is likely behind us. 

The evolving outlook for U.S. monetary policy, coupled with global economic conditions, points to a more stable dollar in the months ahead, even as the Fed’s rate-cutting cycle begins. 

Over the past several months, market participants have been increasingly pricing in the likelihood of earlier and faster rate cuts by the Fed. These expectations have been driven by the perception of a slowing U.S. economy and the Fed’s dovish shifts. 

Real terminal rates, which reflect where the market expects the Fed’s tightening cycle to end, have dropped, from nearly 200 basis points earlier in the summer to under 50 basis points in recent weeks.

Despite this downward shift in rate expectations, Barclays analysts believe that most of the dollar’s depreciation has already occurred. 

The U.S. Dollar Index, which tracks the dollar against a basket of major currencies, has seen a decline since mid-2023. However, the pace of further depreciation is expected to slow as the Fed’s monetary tightening cycle approaches its end.

“That said, the bulk of dollar weakness tends to occur ahead of the Fed easing cycles, and the move has already been chunky by historical standards,” the analysts said.

The dollar typically bottoms shortly after the first cut as the market begins to reassess the economic outlook. This pattern is playing out again, with the market already pricing in future cuts and causing the dollar to weaken accordingly​.

Yet, as the rate-cutting cycle progresses, the market often corrects its expectations for the depth of the cuts. If the U.S. economy avoids a severe recession, the Fed may cut rates more cautiously than anticipated, which could lead to a stabilization or even a rebound in the dollar. 

In milder economic slowdowns, the dollar tends to recover once the market realizes the Fed is not cutting as aggressively as feared.

Barclays underscores that several factors are likely to limit further dollar depreciation. One consideration is the possibility of a U.S. recession. 

Should the economy tip into recession, the dollar may strengthen, as investors typically seek the safety of U.S. assets during times of global uncertainty. 

In this risk-averse environment, the dollar’s safe-haven status could once again come into play, especially against emerging market currencies.

Additionally, geopolitical factors, including ongoing tensions in Europe and China, could provide support for the dollar.

Barclays points out that risks related to U.S.-China trade relations and concerns over European political stability could keep the dollar from weakening further. 

The upcoming U.S. presidential election also raises the possibility of shifts in trade policy, which could introduce new volatility into global markets, indirectly supporting the dollar​.

China’s economic slowdown presents another key factor. As China’s growth continues to falter, driven by a declining credit impulse and weakening consumption, the outlook for the Chinese yuan remains bleak. 

A weaker yuan could lend additional support to the dollar, particularly against Asian and emerging market currencies. Barclays notes that as China’s credit impulse weakens, it tends to correlate with a stronger dollar.

Barclays forecasts some additional USD depreciation in the near term, as the market continues to price in Fed rate cuts. 

However, they expect that the extent of further weakness will be modest, with the bulk of the dollar’s decline already behind us.

 As the Fed’s rate-cutting cycle progresses, the dollar may begin to recover, particularly if economic data points to a milder-than-expected downturn.

“Our new forecasts predict some further USD depreciation into Q4 24, but recovery thereafter,” the analysts said.

This recovery could be driven by a recalibration of market expectations regarding the Fed’s rate cuts, alongside improved global risk sentiment. 

Barclays suggests that while bouts of volatility are still possible, the dollar’s broad downward trend may be nearing its end.