Written by Saqib Iqbal Ahmed
NEW YORK (Reuters) – Traders gauging how to play with further declines in the U.S. dollar are looking to the relative strength of economies around the world, as interest rate shifts from global central banks rattle currency markets.
The index fell 4.8% against a basket of currencies in the third quarter, its worst quarterly performance in nearly two years. Pressure on the US currency increased after the Federal Reserve delivered a massive 50 basis point cut last month, its first cut since 2020.
How long the dollar will continue to fall and which currencies will benefit may largely be a matter of returns. For years, US yields have remained higher than most advanced economies, enhancing the dollar’s appeal against its peers.
This picture is beginning to change, with the Federal Reserve and most other central banks cutting interest rates to protect economic growth. Many traders betting against the dollar do so through currencies that are expected to narrow their return gap with the dollar.
Net bets on a weak dollar rose to $14.1 billion in futures markets, the highest level in about a year, Commodity Futures Trading Commission data showed. However, the dollar’s downward path is likely to be bumpy.
A relatively strong US economy could limit the extent to which the Fed can cut interest rates, further complicating expectations of further dollar declines. Meanwhile, the US presidential election and geopolitical concerns threaten to inject further volatility into currency markets in the coming weeks.
“It’s not necessarily about selling the dollar and buying everything,” said Jack McIntyre, portfolio manager at Brandywine Global. “You have to be a little more selective.”
Although it has changed little over the year, it is down about 5% from its April high, with the currency falling against many of its developed market peers as US yields decline in anticipation of an easing of monetary policy by the Federal Reserve.
Some risks to the dollar’s weak outlook have become more apparent in recent days.
The dollar rose sharply against the pound on Thursday after the Bank of England said it may move more aggressively to cut interest rates if inflationary pressures continue to weaken.
A day earlier, data showed euro zone inflation fell below 2% for the first time since mid-2021 in September, strengthening the case for the European Central Bank to cut interest rates this month, a potential source of euro weakness.
The dollar’s role as a safe haven has also emerged with the escalation of tensions in the Middle East in recent days.
On the US side, Friday’s labor market data could help shape views on the extent to which the Fed may cut interest rates for the rest of the year.
Although futures markets are showing an additional 68 basis points of cuts, the strong number could strengthen the case for more moderate policy easing. However, Christian Dery, head of macro strategy at Capital Fund Management, said, “If we enter a weak phase for the US economy, the market will rule out further downturns in the curve and this will weaken the dollar.”
However, investors believe there is still more downside for the dollar in some corners of the market.
Paresh Upadhyaya, director of fixed income and currency strategy at Amundi US, said he looks for “distinctive stories such as a widening of interest rate spreads caused by divergence in monetary policy.”
His plays on the weaker dollar include positions in the Norwegian krone and the Australian dollar. Norway’s central bank recently kept interest rates at the highest level in 16 years, suggesting any cuts would have to wait until early 2025. Australia’s central bank kept interest rates steady last week and said rate cuts were unlikely in the near term.
Upadhyaya has also been added to a position at the Brazilian Real. Unlike many of its peers, Brazil’s central bank raised interest rates last month as it looked to address the challenging inflation outlook. The Brazilian real has fallen by about 10% against the dollar this year.
Investors said the Japanese yen may also find further support from divergent central bank policies. The Bank of Japan tightened interest rates to 0.25% in July in a historic shift away from a decade-long stimulus program aimed at stimulating economic growth.
Although the Bank of Japan has indicated that it is in no rush to raise interest rates further, the narrow gap between interest rates in Japan and the United States has already seen the yen rise 10% from its 2024 lows against the dollar. CFTC data showed that net bullish bets on the currency against the dollar amounted to $5.8 billion.
“With global central banks also starting to cut interest rates, the biggest winners against the dollar will be the likes of the yen,” said Natsumi Matsuba, head of FX trading and portfolio management at Russell Investments.
An analysis of currency valuations based on measures such as purchasing power parity and real effective exchange rates released by Bank of America Global Research last month showed that the yen and Norwegian krone are among the most undervalued currencies in the developed world. The study found that the dollar and the Swiss franc are the most overvalued.
But whatever their position, investors also have to contend with potential volatility surrounding the US presidential election scheduled for November 5.
Uncertainty in the weeks leading up to the vote may push safety-seeking investors into the dollar. Many investors also believe that a victory for Republican candidate Donald Trump could support the dollar.
“The wild card in any outlook right now for our currency is the US election,” said Brandywine’s McIntyre, who remains bullish on the US dollar, but less so before the currency’s recent decline. “That’s why it’s hard to be so severely convicted.”