U.S. dollar sliding fast, but pace can't last
There are plenty of fundamental economic reasons to hold a long term negative view on the U.S. dollar, but the selling and bearish sentiment currently smothering the greenback may be overdone.
The dollar has lost 5% of its value against a basket of major currencies since President Donald Trump's tariff 'Liberation Day' on April 2, and has fallen 10% since mid-January, when it was its strongest in more than two years.
The economic and policy uncertainty caused by Trump's trade war and its chaotic implementation have dimmed the dollar's allure, while Trump's drive to rip up the world economic order of the last 80 years and his attacks on Federal Reserve Chair Jerome Powell have also alarmed investors.
What's more, if the Trump administration is to revive U.S. manufacturing, reduce the trade deficit and rebalance global trade, a weaker exchange rate must be part of the plan.
Clarity around some of these issues may not come for a while. The U.S.-China tariff truce expires on July 9 and Trump's tax-cut bill may not be finally approved until the July 4 recess, by which time the debt ceiling issue will be coming on investors' radar again.
This is the backdrop against which many investors are now reassessing their exposure to dollar-denominated assets. That includes Treasuries, especially longer maturity bonds, which are feeling the heat from burning worries over Washington's debt and deficits. With the world's reserve currency and reserve asset under pressure, it's little wonder U.S. stocks are under-performing most global peers this year too.
Added together, that's a powerful headwind for the dollar, despite the recent tailwind from the U.S.-Sino trade detente. But as is often the case in financial markets, traders and investors may have gotten a bit ahead of themselves.
Bearish sentiment and positioning are now at extreme levels, according to some measures.
TOO MUCH, TOO SOON
Bank of America's latest global fund manager survey showed that exposure to the dollar this month was the lowest since May 2006, a 19-year low. A net 17% of investors in the survey are now underweight the dollar.
The same survey also showed that a 'U.S. dollar crash on international buyers' strike' is now considered to be the third biggest tail risk to world markets, according to investors, only marginally behind inflation forcing the Fed to raise interest rates.
The multi-year process of 'de-dollarization' may be underway but a buyers' strike is highly unlikely, even in these febrile and uncertain times.
While 'real money' investors like pension and insurance funds, sovereign wealth funds and reserve managers may reallocate capital over the course of several months, speculators and hedge funds move much quicker. And further.
Commodity Futures Trading Commission data shows that hedge funds are holding an overall short dollar position - effectively a wager that the currency will weaken - worth $17 billion, one of the biggest short positions in years. Moreover, as recently as January funds held a net long position worth $35 billion, their most bullish dollar bet in nine years.
Positioning in the yen is particularly extreme - bullish bets on the Japanese currency have never been bigger. With calls mounting for the Bank of Japan to pause its rate hikes and resume bond buying to stabilize the long end of the curve, the yen's upside from here may be limited.
Oddly, the dollar's lurch lower has gone against the latest, hawkish shifts in Fed rate expectations. U.S. rates futures markets are now barely pricing in two quarter-point rate cuts this year, with the first not coming until October. Compare that with four cuts starting in June that traders were anticipating only a couple of months ago.
There are also signs that the dollar's tight and well-established correlation with U.S.-euro zone yield spreads has broken down in recent weeks. But history suggests that correlation will re-establish itself pretty quickly.
The dollar and exchange rates will be a key topic of discussion among finance ministers and central bank chiefs from the Group of Seven nations meeting in Canada this week. They will no doubt also feature in Washington's bilateral talks with key trading partners, particularly in Asia, as trade deals are thrashed out.
The dollar's longer term direction may be lower. In the near term though, a pause or even correction may be warranted.
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