Chief Investment Strategist
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The US dollar has recently faced mounting pressures, raising concerns about whether this signals the beginning of a more sustained period of weakness. August was the dollar's worst month of the year as the July US jobs report and Fed Chair Powell’s comments at Jackson Hole signaled there could be a larger rate cut of 50 basis points coming at the Fed’s September meeting.
The US Dollar spot index (DXY) was down 2.3% in August, registering its second-worst month since the start of 2023 and slipping to over one-year lows.
This came along with US economic data remaining mostly resilient, and soft landing hopes continuing to gain traction. This lands the US dollar in the middle of the ‘dollar smile’ theory, which makes the USD prone to drawdowns as investors go on a hunt for higher yields elsewhere.
The speculator positioning in the US dollar, as a result, has shifted to a net short in the week of August 27 for the first time since January. These developments have led to increased scrutiny of the factors driving the dollar's current trajectory and the risks that could further undermine its position.
Some are looking at the start of Fed rate cuts to put further pressure on the USD, but there could be reasons to expect the trend to reverse, as noted below.
The market has already priced in 100 basis points of rate cuts by the Federal Reserve for this year, reflecting expectations of a slowing US economy. However, this assumption could be overly pessimistic. If economic data remains even modestly resilient, the market may need to reassess its expectations and shift towards a more hawkish outlook for the Fed. Such a shift would be USD-positive, as higher interest rates would make US assets more attractive to investors, bolstering demand for the dollar.
If growth concerns materialize and recession risks escalate to justify market’s expectations for aggressive easing from the Fed, then focus will likely shift back to the dollar's role as a safe haven. In times of economic uncertainty, global investors typically flock to the US dollar, driving up its value. This potential flight to safety could counterbalance any initial pressure from rate cuts, limiting the downside for the dollar.
Despite a slowing US economy, its resilience relative to other major economies remains intact. US exceptionalism, characterized by strong corporate earnings, a robust labor market, and the dominance of the US dollar in global trade, continues to make the dollar an attractive asset. This could counterbalance recent weakness.
Political and economic risks in the Eurozone are becoming more prominent, compounded by a significant economic slowdown in China. The Eurozone's struggles with stagnant growth, inflationary pressures, and high energy costs, along with China's reduced demand for European exports, could add to the euro's weakness. Political instability in key EU nations and potential fragmentation risks further weaken the euro, making the USD more attractive to global investors.
Geopolitical uncertainties continue to create a risk-off environment that traditionally supports the USD as a safe haven. Ongoing conflicts, trade tensions, and potential economic slowdowns in key regions could lead to increased demand for the dollar amidst global risk aversion.
The US election cycle is heating up, and the race still looks tight between Vice President Harris and former President Trump. This introduces a layer of uncertainty that could lead to increased market volatility. Historically, the USD has seen renewed demand during such periods of political turmoil as investors seek safety.
While there are support factors for the US dollar, several risks could exacerbate its current weakness, potentially leading to a more sustained downturn. We highlight key short-term and long-term catalysts that could signal a looming USD crisis.
While the US dollar is currently facing challenges, a full-blown crisis remains a low-probability event unless these warning signs start to materialize. Investors should stay vigilant and be prepared to adjust their strategies if the landscape begins to shift dramatically.
Considering the current environment, it’s important to take a nuanced perspective on the USD’s path. Potential Fed rate cuts or recession risks may strengthen the Japanese yen (JPY) and Swiss franc (CHF), but the Canadian dollar (CAD) and euro (EUR) face higher risks, potentially offering underlying support for the USD. This is especially relevant given the euro's significant weight of over 50% in the DXY index. Investors should carefully monitor these dynamics as they navigate the complexities of the currency market.
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