Dollar's Strong Cycle Near End Amid $10B in Shorts?

The month of August has witnessed a notable dip in the US dollar index, which has fallen by 2.2%, marking the most significant decline since November of the previous year. During intra-day trading, it even touched one of its lowest points in the current cycle of dollar appreciation. This erosion in the greenback's value has been largely linked to market expectations regarding a shift in the Federal Reserve's monetary policy. Futures contracts on federal funds suggest that a near 100 basis points rate cut by the Fed is anticipated within the year. This expectation has allowed currencies outside the US to make a pronounced rebound, with data from the Commodity Futures Trading Commission (CFTC) revealing a surge in short positions on the dollar, climbing to a substantial $9.8 billion— the highest recorded since January.

The narrative surrounding the dollar's robust phase now appears shaky. After initiating its latest bullish phase with interest rate hikes back in March 2021, the dollar index peaked at 114.7 in September 2022. However, as inflation figures reached their zenith and began to recede, the dollar index fell below the 100 threshold in June 2023. Recent months have seen the dollar oscillate amid persistent inflation pressures and various supply chain issues. As the latter half of the year commenced, with inflation experiencing a month-over-month decline to zero, the Federal Reserve's focus has gradually pivoted from price stabilization towards employment metrics. This shift has laid the groundwork for further depreciation, especially as the dollar recently approached the critical 100 mark again.

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According to a report sent to the Financial Times by the Chief Investment Office at UBS Wealth Management, the cycle of a strong dollar is reaching its conclusion. First, signs are emerging that the pace of the US economy and consumer expenditure are on a downwards trajectory, which in turn will weaken the dollar's foundational support. Despite previous backing from significant fiscal stimulus packages amidst robust immigration figures and consumer resilience, dwindling post-pandemic savings are manifesting in slowing consumer spending. Furthermore, indications of weakness in the labor market, particularly in sectors that significantly benefited from pandemic-related expansions, are becoming more evident.

Second, the advantage that US interest rates previously held over global counterparts is diminishing. The prolonged high inflation rates in the US have finally begun to converge towards the Federal Reserve's long-term targets. The Fed will have to take swift action to ease the currently restrictive interest rate levels to effectively tackle the dual challenges of curbing inflation while maintaining sufficient employment. As both nominal and real rates in the US gradually decrease, the strong yield narrative associated with the dollar will also diminish, lessening its appeal.

Last but not least, investors are now turning their attention to structural issues that pose long-term challenges. Fundamental concerns like the persistent fiscal and trade deficits in the US have often been overlooked until market sentiments take a shift. Factors such as a deceleration in GDP growth alongside diminishing yields may prompt a reassessment of the dollar's inflated value, particularly as government finances begin to tighten under the strains of a weaker international balance of payments. Historical trends suggest that currencies that become overvalued in the face of shifting fundamentals tend to suffer significant corrections.

The anticipated rate cuts by the Federal Reserve have also brought a sense of relief to many central banks in developed economies. In early July, the exchange rate of the yen against the dollar fell below the critical threshold of 160, plummeting to a 38-year low. Despite numerous interventions from the Bank of Japan to stabilize the yen against rampant dollar purchases, the efforts appeared to fall short. However, with the Bank of Japan now considering rate hikes and expectations building around the Fed's impending rate cuts, the yen has managed to rally over 10% from those low levels, temporarily alleviating some of its immediate risks.

Derek Halpenny, the head of global markets research at MUFG EMEA, commented, “Following the interest rate cuts, we expect the dollar index won’t bounce back as frequently as it has over the past two years. This represents a seismic shift, indicating that the dollar-yen pair is on a downward trajectory.”

In a stark contrast to two years prior, when then-Prime Minister Liz Truss's controversial policies sent the British pound tumbling to historic lows and the euro to parity with the dollar—fueling inflation pressures across the board—the current climate marks a turnaround. The pound and euro have emerged as the top-performing major currencies this year, with the pound surging above 1.30 against the dollar, representing a more than 25% increase from its historical lows. Meanwhile, the euro reclaimed the 1.12 mark against the dollar recently due to the markets expecting rate cuts from the ECB and the BoE, which have been slower than the Fed.

The momentum in the UK economic landscape has also strengthened. Recent statistics released on Monday indicated that the final value of the manufacturing Purchasing Managers' Index (PMI) for August rose from 52.1 in July to 52.5, marking a peak not seen since June 2022 and maintaining consistency with earlier estimates for August. Market participants anticipate the Bank of England will retain interest rates stable this month and possibly consider a rate cut in November—marking its second cut since 2020. Bank of England Governor Andrew Bailey had previously stated that it’s premature to declare an all-out victory over inflation, particularly with inflation challenges persistent in the services sector.

For emerging markets, the weakening dollar presents a dual advantage—streamlining the pressure of imported inflation while simultaneously providing local central banks with the necessary room to maneuver towards stimulating economic recovery. In August, the Chinese yuan witnessed its highest monthly appreciation this year, with the yuan's middle rate against the dollar adjusted up by 222 basis points to 7.1124. The onshore yuan appreciated cumulatively by 1380 points to settle at 7.0881 against the dollar, while the offshore yuan climbed up by a similar margin, even charting a breach of the 7.08 mark for a time.

This appreciation of the yuan is primarily attributed to the weakening dollar, a trend likely to endure especially if exporters begin to offload their accumulated dollar reserves. Lynn Song, the chief economist for Greater China at ING, projected that the yuan will gradually strengthen, forecasting an improvement to a dollar-yuan exchange rate of around 7 by year’s end—around 1% higher than its current level.

Moreover, Standard Chartered’s senior economist for Greater China, Liu Jianheng, noted that the bank’s Renminbi Global Index (RGI) remains on the rise, driven by a growing interest from overseas investors in yuan-denominated assets. The expanding holdings of such assets and robust issuance of dim sum bonds have contributed to this trend. With off-shore yuan deposits expanding—particularly as the sentiment in Hong Kong stock investments sees improvement and cross-border capital flows gain momentum—the recent bullish inclination remains promising. Standard Chartered anticipates significant growth in offshore yuan deposits in the latter half of the year driven by the strengthening demand conditioned by the Fed's projected rate cuts.

As the dollar slips, it has also provided a boost to other developing currencies, especially in Asia. The Philippine peso recorded its best monthly growth in nearly 18 years, while the Indonesian rupiah saw its most substantial rise in over four years.

With the Fed's anticipated rate cuts, there is also optimism regarding enhanced monetary policy flexibility in emerging markets. Ehsan Khoman, the head of emerging markets research at MUFG, suggested that countries such as the Philippines, Singapore, South Africa, South Korea, Taiwan, and Turkey are likely to follow suit, paralleling the moves of their Latin American and Central and Eastern European peers in the coming months.