US dollar's 2022 rally screeches to a halt

An extraordinary U.S. dollar rally in 2022 skidded to a stop in November as inflation showed signs of peaking and anticipation built that the Federal Reserve could soon slow its aggressive tightening of monetary policy.

The Dow Jones FXCM Dollar Index fell nearly 4% in November after climbing about 11% through the first 10 months of 2022. The index, which measures the dollar's value against the euro, the British pound, the Japanese yen and the Australian dollar, ended November at its lowest point since Aug. 17.

"It has been an abrupt turnaround for the U.S. dollar this month," said Lee Hardman, a currency analyst with MUFG Bank.

The dollar has fallen against other currencies as confidence has mounted among market participants that the Fed will slow down the pace of its rate hikes and then pause them sometime in the first half of 2023, Hardman said.

The Fed has raised its benchmark interest rate 375 basis points since March, creating a rate differential with other central banks that has pushed up the dollar. But the dollar began its decline in early November when the latest consumer price index, the market's preferred inflation metric, increased by 7.7% from October 2021 to October 2022, down from 8.2% the previous month. This boosted speculation that inflation may have peaked and could result in the Fed easing up on its push to fight rising prices through higher and higher rates.

While Fed Chairman Jerome Powell has dismissed the significance of a single month of inflation data, he has also said the central bank is prepared to slow its tightening path, likely through a 50-basis-point hike at its December meeting after four-straight meetings with 75-bps hikes.

"It makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down," Powell said during a Nov. 30 speech.

Peak hikes

The Fed's openness to slowing its rate-hike pace has been the biggest factor in the dollar's underperformance in November, said Craig Erlam, a market analyst with OANDA.

"I think we may have seen the peak in the dollar in the short-term as the Fed has raised very aggressively and will find it hard to justify not slowing down unless the data takes another nasty turn," Erlam said.

The dollar, which gained significantly on all of its G10 peers through the first 10 months of the year, lost ground to all of them in November.

The New Zealand dollar gained more than 7.4% against the U.S. dollar in November, though it is down more than 9% to the greenback since the start of the year. Meanwhile, the Japanese yen gained 5.9% on the dollar during the month and remains down about 17.4% on the year.

Foreign currencies rallied against the dollar partly on views that Europe's energy supply crisis may not be as bad as initially feared, Hardman with MUFG said. In addition, there was "building optimism" throughout the foreign exchange market that China's zero-COVID strategy could soon ease.

In addition, "softer" inflation readings in Europe and Australia have bolstered optimism that inflation and central bank hawkishness may have peaked, said Jane Foley, head of FX strategy at Rabobank.

"This is soothing risk appetite," Foley said.

Choppy conditions

Still, central banks remain concerned about persistently high inflation and could look to continue to tighten policy.

"This suggests the potential for some choppy trading conditions for risky assets and the safe haven [dollar] with central bank commentary reining in risk appetite," Foley said.

It is still too early to say if November will prove to be a turning point for the dollar as weak economic activity across Europe or ongoing yield curve control efforts by the Bank of Japan could further support the dollar against its G10 peers, said Fawad Razaqzada, a market analyst with City Index and FOREX.com.

As the Fed continues to hike rates into 2023, the dollar's downside will likely be limited, Razaqzada said.

"It could be a while before they pause the hiking cycle and go in reverse," Razaqzada said. "This should help provide a floor for the greenback in the medium-term outlook."