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When the economic storm clouds are gathering, a U.S. recession is on the horizon, stocks and long-term bond yields are falling, and the U.S. yield curve is close to inverting, you’d expect the dollar to strengthen.

Investors hunker down, U.S. capital flows back home and there’s a surge in global demand for safety and liquidity. All that points to a stronger dollar, especially when the Fed is virtually the only major central bank tightening policy, meaning U.S. interest rates and yields are significantly higher than those elsewhere in the developed world.

But after the Fed raised rates on Wednesday for the ninth time this cycle to 2.25-2.50 per cent, and signalled it will continue withdrawing postcrisis stimulus next year, the dollar fell. Sharply.

The U.S. currency had one of its worst days of the year on Thursday and is on course for its biggest weekly fall since the week immediately following the bout of “Volmageddon” stock market instability in February.

So what gives? There’s no obvious reason, but there are a few plausible explanations.

The first is market positioning. Investors and traders collectively hold a huge long dollar position, so there’s a natural bias toward lightening that load as the year-end draws closer.

Bank of America Merrill Lynch’s latest monthly poll released this week showed that the “long dollar” trade is the most crowded trade in the world among the fund managers surveyed.

Hedge funds and other speculators trading U.S. futures markets have been net long of dollar since June, and earlier this month increased it to more than $31 billion, the highest in nearly two years.

They began scaling it back last week, but at $28.5 billion it is still substantial, and there’s certainly more room to unwind in the coming weeks and months.

That dovetails with the broader consensus view in currency markets that the dollar next year will give back some of its gains from this year. The latest Reuters poll of more than 60 currency analysts, taken Nov. 28-Dec. 5, points to the dollar weakening by around 5 per cent next year.

So perhaps, as 2018 ends and investors set out their stall for 2019, the dollar is reacting accordingly.

Of course, exchange rates are relative, so U.S. monetary policy is only one half of the dollar’s equation. All else being equal, if the Fed goes slower on rates than it had signalled, the dollar will hold its ground only if other central banks shift their stances by a similar magnitude.

But euro zone, U.K. and Japanese policy is already so loose – interest rates in the euro zone and Japan are negative – that there is limited room for these central banks to ease. On the margins, a more dovish Fed and neutral ECB, BOJ and BoE is a drag on the dollar.

Futures markets barely ascribe a 50 per cent probability to the Fed raising rates even once next year and are beginning to price in a move toward a cut in 2020. The Fed itself on Wednesday signalled two hikes next year and one in 2020.

Clearly, money market traders expect the Fed to row back even more. This isn’t a new phenomenon – it’s been years since the market had a more hawkish view on U.S. rates than the Fed.

It’s also worth bearing in mind where the U.S. policy cycle currently is. As Steve Barrow at Standard Bank points out, diminishing marginal returns set in, meaning rate hikes early in the tightening cycle – or even before the cycle starts – lift a currency much more than late-cycle hikes.

“And you can get to a point where rate hikes become bearish if the market fears overkill, which is the case here,” Barrow says, also noting that the Fed is under unprecedented pressure from the White House not to continue tightening.

Finally, there’s a long term, structural factor weighing on the dollar and supporting the euro that may not factor in day-to-day FX market activity, but which has come back under the spotlight in the last 24 hours.

Figures on Wednesday showed that the U.S. current account deficit widened to $124.8 billion in Q3, the widest in 10 years. The $23.6 billion widening from Q2 was the joint-second biggest quarterly current account balance deterioration in history.

Meanwhile, data on Thursday showed that the euro zone posted a seasonally-adjusted current account surplus of 23 billion euros in October. The bloc’s surplus so far this year stands at 284 billion euros, on course to match last year’s record 353.4 billion euros.

Throw all that together and the dollar’s wobbles may not be all that surprising, even against the dollar-friendly backdrop of rising U.S. interest rates and deteriorating global economic and market conditions.

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