03.05.202311:31 Forex Analysis & Reviews: Haunted by shadows from its past, USD to slump by 20%

The US dollar index is in a prolonged decline. This is the fourth long-lasting bearish trend in the last five decades. The US dollar index is expected to drop below 100.00 in the coming one-two months. Still, this level is higher than in April of the previous year. All in all, the index may slump by 20%.

Bank of America experts recalled what happened during previous declines. In early 1971, the US dollar index began to decline from 120.00 and fell to 82.00 in October 1978. The next peak was conquered in February 1985, just below 165.00, and the lowest level was recorded in September 1992, around 78.00. The third bearish cycle lasted from July 2001 (121.00) to March 2008 (lower than 71.00). Finally, the fourth cycle of the dollar's free-fall began last September with a value of 114.80.

Economists from Bank of America are right: the dollar index chart clearly shows the beginning of its long-term bearish trend. The timeframe indicates that the index may drop to the psychologically important level of 100.00 points for a start, and then accelerate its decline as the US government debt approaches its limit, which could happen in the summer of 2023. The current situation for the dollar is unique: a process of de-dollarization is picking up steam. It is problematic to accurately predict how steep it will fall in this cycle.

The ongoing bearish trend of the dollar is triggered by several reasons. Hypothetic rate cuts by the Federal Reserve will reduce investors' interest in dollar-denominated assets. The expected recession in the US economy in 2024 may further weaken the greenback's value.

The dollar is currently overvalued and trades at a 19% premium compared to its fair value according to the purchasing power parity model. Therefore, within the ongoing bearish cycle, the US currency may depreciate by 20%, as already noted above, relative to the basket of major currencies, reaching the 80.00 point level on the index.

The US dollar before the Fed's decision

The conditions for the dollar's growth are currently most unfavorable. Despite some spikes in the US currency in recent days, it still looks vulnerable. Attempts to continue the climb above the 102.00 mark seem more like agony.

Everyone understands that the time of the dollar's growth is coming to its logical conclusion, at least in this cycle.

Of course, Jerome Powell can encourage the buyers with hawkish comments, but the picture of the US economy, considering the banking crisis, suggests otherwise. It's time to think about a pause. Perhaps the tightening in May will be the last one, as the majority of market participants expect.

On Tuesday, fears about financial stability intensified again after the second-largest banking collapse in the country's history. Among creditors, shares of PacWest and Western Alliance plummeted by 27.8% and 15.1%, respectively. JPMorgan, which gained momentum in the previous session after acquiring First Republic Bank, lost 1%. In addition to bearish sentiment, the number of job openings from JOLTS reached its lowest level in nearly two years, raising concerns about a potential slowdown in the US economy.

Traders are now cautious about opening new positions in anticipation of the Fed's policy update following its two-day meeting.

Important for the Fed:

GDP in Q1 2023 grew by 1.1% in annual terms. In the previous quarter, the national economy expanded by 2.6%, though analysts forecasted a GDP increase of 2%. Markets focused on the inflation indicator for the quarter. The GDP deflator showed a growth of 4% (QoQ) for the first three months of this year, higher than the consensus forecast of 3.7% (QoQ) and the previous figure of 3.9% (QoQ).

The key factor for the rate hike was strong consumer demand in the first quarter. Investors carefully monitor the PCE price index which is the main inflation indicator tracked by the Fed.

Thus, the overall inflation rate in March fell to its lowest level since May 2021, reaching 4.2% in annual terms compared to 5.2% in February. Month-over-month inflation growth slipped from 0.3% to 0.1% (the weakest level since July of the previous year).

The more significant core inflation indicator decreased less than the market expected - from 4.7% in February to 4.6%, with a forecasted decline to 4.5%.

The core inflation indicator has been in the range of 4.6-4.7% for four months, confirming that inflation has been firmly stuck above the Fed's target of 2%.

Meanwhile, weak economic growth forecasts suggest difficulties for the Fed in raising rates without hurting the economy.

Markets assess the probability of a 25 basis point rate hike as nearly 100% and then expect an announcement of a pause in the tightening cycle.

An alarming harbinger for the Fed:

In the Minnesota healthcare industry, new specialities have emerged: nurses focused on persuading their colleagues to stay at work. This has also sparked discussions about limiting workload and increasing unionized nurses' wages.

Authorities, concerned about the labor shortage in the state where population growth has stalled, have opted for a cover-up tactic. This includes proposals for training in fast-growing professions and housing subsidies for small businesses wishing to hire workers with limited abilities.

Central bank officials are interested in when wage growth may slow down, as they try to cool the economy and inflation. "Not anytime soon, the situation isn't leveling off," state representatives note.

The labor shortage has been haunting the US since the early months of the pandemic. As fears about health waned and support programs ended, it became clear that the pandemic had changed the way Americans work: from in-demand professions to people's willingness to engage in them.

These so-called shifts could be one reason why it's more difficult than anticipated for the Fed to slow down the labor market, which is trying to match workers with open vacancies. This could also dampen any job losses resulting from the central bank's efforts to curb overall demand and contain inflation.

Minnesota's experience, where a strong industrial and corporate base has faced steady population growth, suggests that the process of finding a balance for the economy, wages, and inflation will be neither fast nor cheap.

On the other hand, there is some evidence supporting the hope shared by many Fed officials that as the economy slows. Companies will reduce the current high level of job vacancies. At the same time, they will not lay off employees who may be difficult to rehire.