The belief among investors that the Federal Reserve would cut rates aggressively in 2024, even in the absence of a growth or employment shock had become near-universal even before the central bank’s decisively-dovish pivot at the December policy meeting.

Inflation is fading quickly. Energy and manufactured goods prices are still coming down, and our estimates suggest that the Fed’s preferred measure—the core personal consumption expenditures index—rose less than 2 percent on an annualized basis over the six months ended in November. Unemployment rates remain near historic lows.

With the legacy of a three-year surge in deficit spending and credit growth still flowing through the economy, consumer spending remains astonishingly strong, and business confidence is stabilizing. The ‘vibecession’ – the deep sense of economic pessimism among consumers, businesses, and the media – is showing signs of ending.

Daily news sentiment score, 3-month moving average

A dramatic easing impulse is hitting the real economy. The number of senior loan officers tightening credit terms fell sharply in the Federal Reserve’s latest survey, suggesting that financial institutions are turning more optimistic – and implying that headline growth rates could hold up remarkably well for many months yet.

Senior Loan Officer Survey, % of respondents

Markets risk turning overoptimistic on underlying trends: Fiscal support is turning negative, consumer spending is running on fumes as savings rates run well below, and pre-pandemic norms diffusion indices are pointing to a renewed rise in unemployment rates.

Non-farm employment diffusion indices, share of industries reporting growth (unchanged cut by half)

As the lagged effects of monetary tightening become increasingly evident in rate-sensitive sectors, we expect recessionary headwinds to grow stronger, culminating in a downturn beginning before June 2024. Warning signs should multiply in the coming months, with economic surprise differentials narrowing against the US.

GDP-weighted economic surprise indices

Federal Reserve officials are clearly signalling increasing discomfort with the level of restrictiveness implied in real policy rates. If all else were equal, the dollar would come under sustained selling pressure in the months ahead.

But exchange rates have already moved dramatically: Hedge funds and other large speculators are holding a net short position against the dollar for the first time since September, and the greenback has fallen more than 4 percent from its October highs as markets have turned optimistic on returns outside the United States.

And all else isn’t equal: Although inflation is headed in the same direction across the planet, differences in sensitivities could mean that yields come down harder outside the US. Having undergone a painful deleveraging process after the 2008 global financial crisis, US household and corporate balance sheets look solid in comparison with their international brethren. 30-year mortgages mean a smaller proportion of homeowners is exposed to an interest rate shock, and – because the bulk of American firm-level financing is done through bond issuance – debt rollover costs are spread over much more manageable time horizons than in the more bank-dependent British, Canadian, and European financial systems.

GDP-weighted rate differentials

The economic consequences of post-pandemic monetary tightening are still likely to be felt more acutely in rate curves elsewhere. The appeal of previously-strong high-carry units could diminish in the months to come as emerging market central banks move to cut policy more aggressively, and the extent to which currencies like the euro—which still makes up almost 58 percent of the DXY dollar index—can sustainably strengthen, looks relatively limited.

For all their drama, presidential elections typically have very little impact on the economy’s near-term direction, and often leave exchange rates effectively unmoved.

But in 2024, the stakes for currency markets will be higher. In early campaigning, Donald Trump – the presumptive Republican nominee – has threatened to apply a “universal baseline” ten-percent tariff on all imports – a step that could inflict damage on the dollar’s major counterparts in a repeat of the dynamics seen after the vote in 2016. We think volatility term structures in foreign exchange markets will develop kinks around November’s polling date as the year progresses, with the March party primaries serving as a catalyst for position adjustment.

Duties as a share of imports for consumption, %

We are directionally aligned with consensus – like most observers, we believe the greenback will ultimately weaken in 2024 – but we think its descent will be more turbulent than others expect.

A number of factors could upset prevailing views: If markets begin questioning the soft landing thesis in earnest, “dollar smile” dynamics could see capital flows re-routed back into US financial markets, triggering a sustained rally in the greenback. Signs of stubbornly sticky inflation might drive a reappraisal across developed-market yield curves, weighing on high-beta currencies. A stimulus-led acceleration in China could lift commodity benchmarks and impact price expectations throughout the global economy. Or, on the campaign trail, an increasingly combative Donald Trump might threaten to destabilize economies with trade links to the US. But the most likely scenario, in our view, is one in which increased dispersion in economic growth patterns leads to greater divergence between central banks, keeping cross-currency rate differentials on a dollar-favourable footing.

The dollar will remain vulnerable to pullbacks throughout 2024, but clear directional trading narratives are unlikely to remain intact for long, and the currency could emerge stronger than many currently expect.