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Investors are betting on further weakness in the US dollar after its recent falls, as the fallout from last month’s banking crisis limits how far the Federal Reserve can raise interest rates and US investors hunt overseas for returns.
After an 18-month bull run that took it to a 20-year high against a basket of currencies in September last year, the greenback has been in retreat as analysts have scaled back their expectations of US interest rate rises. Last week the dollar hit its lowest level in a year against the euro, as well as against the broader currency basket.
Despite the falls, hedge funds and some analysts believe the greater potential for rate rises in the eurozone, where economic growth is improving, and the UK will continue to put downward pressure on the dollar.
“The dollar has had a fantastic run but it’s starting to turn,” said Alan Ruskin, chief international strategist at Deutsche Bank. “The pessimism we saw last year about Europe following the start of the Russia-Ukraine war is fading and, at the same time, other currencies have positive stories of their own.”
Speculative traders have roughly doubled their short positions in the dollar since mid-March, according to calculations by Refinitiv based on CFTC data, indicating that hedge funds are betting that the dollar will fall further. In the latest weekly data, which runs to April 10, speculators added to their short positions, bringing the total to $10.73bn.
Deutsche’s Ruskin highlighted the rosier economic picture in Europe, and speculation that Kazuo Ueda, the new governor of the Bank of Japan, might ease its long reliance on ultra-easy monetary policy amid upward pressures on interest rates, which are key drivers of currency moves.
The European Central Bank is widely expected to raise interest rates by a further three-quarters of a percentage point, to 3.75 per cent, by the summer as growth and tight labour markets stoke fears that the battle against inflation is not fully won, in spite of softer headline price rises.*
And although Ueda has so far stuck with his predecessor’s strategy, that has failed to dent speculation that Japan will look to unwind gradually the BoJ’s policy of controlling its yield curve to help keep interest rates low.
In the UK, markets are almost completely pricing in a half-point rise by the Bank of England by September.
In contrast, after a widely anticipated quarter-point rise at its May meeting, markets expect the Fed to soon start cutting interest rates if growing expectations of a US recession are borne out.
The recent US banking crisis has also weighed heavily on the dollar.
Following the collapse of three banks in a single week in March, a regular survey by the Dallas Federal Reserve showed a sharp drop in bank lending volumes across the board. Several sets of job data have also pointed to softer labour markets, although the most widely-watched, the monthly payrolls report, has not supported that yet.
“The shock to US banks . . . reinforces the idea that the US could go into a recession before other major economies” which is negative for the dollar, said Ebrahim Rahbari, chief currency strategist at Citigroup.
Meanwhile, the Fed’s support for the banking system, including a new lending facility, has partially reversed its efforts to shrink its balance sheet. Known as quantitative tightening, the reductions were another way of reducing excess liquidity in the system, but the Fed’s need to funnel cash to wobbly regional banks has undermined those efforts.
“Fundamentally, exchange rates are an extension of monetary policy — [the] dollar had a great run as the Fed wanted to tighten policy,” said Chris Turner, head of FX strategy at ING. “That’s all changed at the start of this year with the signs of a slowdown which has been exacerbated by the banking crisis.”
However, funds’ bets on further dollar weakness could be caught out if investors suddenly rush for havens in the event of a crisis.
Current conditions weighing on the dollar “could evaporate fairly rapidly if the markets sense another weak link in the financial sector or global economy as the world adjusts to higher rates”, said Jane Foley, head of foreign exchange strategy at Rabobank. “[The] dollar could move quite a lot higher without much notice.”
And, as has been the case this year, any path to further dollar weakness is likely to be bumpy as investors consider how far central banks will need to tighten monetary policy to control inflation.
“If we look back this year, in January it was like a Goldilocks scenario as headline inflation came down. Then, in March, because of the banking turmoil, the market weakened,” said Athanasios Vamvakidis, head of G10 foreign exchange strategy at Bank of America.
“It won’t be a straight line. It’s going to be a rollercoaster ride.”
*This article has been amended to clarify the market expectations for the European Central Bank’s main interest rate this year
