Dollar falls from peak, peer currencies rally on views of less hawkish Fed

The U.S. dollar has clearly peaked from its highs late last year, and where it heads next likely depends on the future paths of inflation, the labor market and the Federal Reserve's ongoing rate hike push.

The Dow Jones FXCM Dollar Index has fallen more than 5% since Nov. 2, 2022, when Fed Chairman Jerome Powell indicated that the central bank would likely slow, but not stop, the pace of rate hikes. The index, which measures the dollar's value against the euro, the British pound, the Japanese yen and the Australian dollar, previously climbed over 9% from March 17, 2022, when the Fed began hiking rates after roughly two years of keeping them near zero, to Nov. 2.

The dollar tends to rise with rate hikes as investors move to dollar-denominated investments, such as U.S. Treasury bonds, in order to take advantage of rising interest rates. A strong dollar can lower the price of foreign goods but increase the price of goods in overseas markets and chill global demand. The dollar rally last year contributed to rising inflation worldwide and increased the costs of foreign debt service.

The decline in the dollar, after its historic rally, has been primarily driven by weakening inflation data, which has fueled speculation that the Fed could soon stop hiking rates and may even cut rates late this year, said Derek Halpenny, head of research at MUFG. The consumer price index, or CPI, the market's preferred measure of inflation, saw six straight months of annual declines after reaching the highest levels in more than 40 years earlier this summer.

"Weaker CPI is giving markets more confidence that the Fed will stop hiking at about 5%," said Halpenny. "Also, the U.S. data has weakened notably, giving rise to recession fears, which is helping to maintain expectations of rate cuts by the end of the year."

The Fed has hiked rates by 425 basis points since March, including four increases of 75 bps each. After the Fed's November 2022 meeting, Powell indicated that the pace of increases would likely slow and the central bank followed through with a 50 bps hike in December. The Fed is expected to announce a 25 bps increase after its next meeting on Feb. 1.

Since the November 2022 meeting, the dollar's G-10 peers, which lost considerably ground to the dollar earlier in the year, have all gained against the greenback.

The Japanese yen, for example, lost about 26.2% to the dollar from March 17, when the Fed first raised rates, to the end of that November meeting. The yen has gained about 14.5.% since the November meeting concluded.

While the dollar's peers have rebounded on China's gradual reopening and an improved economic outlook in Europe, the rally has been largely driven by Fed expectations. But, if those expectations crumble and the Fed continues to hike rates due to persistently sticky inflation or ongoing tightness in the labor market, dollar strength could return, said Edward Moya, a senior market analyst at OANDA.

"The risk that the Fed will need to resume tightening is a real one and that question won't be answered for a while," Moya said. "If the Fed raises rates above 5.50%, then the dollar will be ripe for a major rally."

Additionally, recession risk could bolster the dollar and send it back to levels not seen since last year.

"A significant economic deterioration and sharp sell-off in global stock markets could see a flight towards the U.S. dollar," said Michael Hewson, chief market analyst with CMC Markets.