Why investors don't expect the dollar selloff to last beyond current rout

The dollar has notched up its worst week since the early days of the coronavirus pandemic, but analysts think a long-running surge for the greenback might not be over just yet.

The Bloomberg Dollar Spot Index slumped about 3.5 per cent this week, its biggest loss since March 2020.

Investors had been trimming bets on the dollar before Thursday’s US inflation data, with a slowdown in prices leading to a pummelling in the index’s worst one-day performance since 2009 as traders eased back bets on how much policy tightening they expect from the Federal Reserve.

The latest selling means the dollar gauge is now 6 per cent below the record peak it hit in late September, with the yen the main beneficiary.

While the moves suggest the greenback could stay under pressure in coming weeks on bets the Fed will start increasing interest rates in smaller increments, market participants remain cautious that the trend will continue in the longer run.

“The dollar peak might be past us, but a dollar downtrend may not be there yet,” ING Groep analysts wrote in a note, adding that the Dutch bank remains “moderately bullish” on the dollar into year-end.

The Bloomberg Dollar Spot Index climbed by more than 22 per cent from its mid-2021 low to its September 2022 peak and even with recent declines, it is still up more than 14 per cent from last year’s nadir.

That strength has rippled across markets, exacerbating the cost of dollar-denominated goods such as oil and complicating policy around the world.

US stocks and bonds rallied this week as the dollar slid.

Strategists at MUFG said that a weaker dollar was now “justified”, while adding that the scale of the move clearly reflects to some degree the “pain trade” seen earlier in the week when investors cut back on overly big bets on the dollar.

Instead, funds have been piling into the yen, up more than 5 per cent this week after hitting a three-decade low less than a month ago.

Currency strategist Lee Hardman likened the market’s positioning and the sell-off in the dollar to an elastic band stretched in one direction, “and when you let go, you get a bigger reaction the other way”.

Given the large scale of dollar bets that have accumulated this year, he sees the possibility of a further 2 per cent to 3 per cent move lower in the US currency before the end of the year.

That could take it down towards 130 against the yen from around 139 at the moment, while against the euro it could weaken to about 1.05 from present levels around 1.036.

But with a global recession looming, a war in Ukraine continuing and growing signs of a slowdown in China, it could be too soon to aggressively sell the dollar, which is often viewed as a haven in times of trouble.

“It’s inevitable that once the turn has come, there was going to be a sharp move to the downside, which is what’s playing out,” Mr Hardman said.

“Now, the risk is that the move will be overdone, as we’re still far from an end to the Fed tightening cycle at this point.”

Traders will be on the lookout for any further signs of a cooling US economy that could enable the Fed to ease back its tightening following a series of jumbo rises.

Four officials have backed a relaxation even as they stressed that monetary policy must stay tight.

A deeper dollar sell-off would require more confidence that inflation is falling back quickly and speculation that the Fed may need to start cutting rates because recession risks, Mr Hardman said.

But such a situation could, in turn, spark haven demand for the greenback, he added.

For technical chart watchers, the dollar could extend its recent losses all the way down to August lows, according to several momentum indicators.

A key support level, the 32.8 per cent Fibonacci retracement of the May 2021-September 2022 rally, is 1.3 per cent lower than current spot levels.

That could be as far as the retreat goes, if options are any guide.

Risk reversals, a barometer of market positioning and sentiment, have retreated to the least bullish sentiment for the greenback since May, yet show that investors are not convinced of a huge sell-off.

“Risks are that the positioning squeeze could continue,” said Alex Jekov, a Group-of-10 currency strategist at BNP Paribas.

“But it’s tough to argue that this necessarily will elicit a huge turn in the dollar in the medium term given that the CPI data is one print and we haven’t changed our terminal rate forecast, which ultimately is key for the dollar.”