Wall Street’s bearish stance toward the dollar, about as pronounced as it’s been since early 2022, is on the cusp of a serious test.
(Bloomberg) — Wall Street’s bearish stance toward the dollar, about as pronounced as it’s been since early 2022, is on the cusp of a serious test.
Markets are entering a stretch that’s full of risk, with pivotal central bank meetings looming and the clock ticking on the all-important US debt-ceiling standoff. It all comes against a backdrop of worries about a potential US recession — or even a stagflation scenario — after the Federal Reserve ratcheted up borrowing costs to tame inflation.
And yet instead of running for shelter, foreign-exchange traders seem to be becalmed. The amount of major-currency volatility implied by options is roughly as low as it’s been in the past year, testing levels that often precede periods of turbulence and dollar gains.
Those who predict dollar losses point to the potential for the Fed to soon end its rate increases, possibly after another hike expected Wednesday, and for other central banks to catch up with their own tightening. The Bloomberg Dollar Spot Index has lost about 1.4% in 2023 in part on that outlook, trimming the past two years’ gains.
The dimming enthusiasm toward the greenback shows through in futures positioning, which is around the least bullish since 2021; in forecasts that the currency will weaken by year-end versus the euro and yen; and in depressed demand for options to hedge against dollar gains over the next 12 months.
If history is any guide, that narrative could be set for a challenge. That risk is based on the dollar’s performance during the 2011 US debt-limit standoff, how the currency fared during past recessions and its tendency to climb during breakouts in volatility.
Below is a breakdown of these scenarios.
Debt-Limit Standoff
It may only be a matter of weeks before the impasse over raising the $31.4 trillion US debt-ceiling puts the government at risk of default. Treasury Secretary Janet Yellen told Congress on Monday that her department may run out of cash as soon as June.
Goldman Sachs Group Inc.’s Dominic Wilson and Vickie Chang looked back at how markets fared in 2011, when a battle over the cap pushed the Treasury to the brink.
Back then, it netted out to strengthen the greenback: a broad measure of the dollar climbed almost 2% from late July through early August, a narrow span in which the strategists determined US developments, rather than Europe’s debt crisis, were the main drivers.
“The risks from a debt-ceiling crisis are more likely to present as a large but temporary shock to US growth expectations” given the prospect of disruptions to government payments, they wrote in a note last month. Declines in US equities, credit and bond yields and higher equities volatility are a likely result, they said.
In exchange rates, they said, “the most consistent predictions are for strength in the JPY and weakness in cyclical currencies, particularly those with strong linkages to the US,” such as the Canadian dollar and the Mexican peso.
Recession Risk
Debt-cap worries are adding to angst over a potential US recession as credit conditions tighten and growth slows.
It’s an outcome that has typically boosted the dollar’s haven appeal, says Jonathan Petersen at Capital Economics. He analyzed US recessions over the past 40 years and found that all but one triggered dollar strength.
The exception: after the fall of the Berlin Wall and the collapse of the Soviet Union supported economic momentum in Europe, while the US sank into a downturn in 1990-1991.
He expects a US recession starting this quarter or the next, adding 10% to the dollar’s value in the second half of the year.
It’ll amount to “one last rally in the dollar,” he said from London. The recession won’t last long, and neither will dollar strength as the Fed will start cutting rates, he forecasts.
Volatility Trigger
Implied volatility has extended its decline across major currencies. JPMorgan Chase & Co.’s one-month G-10 FX Volatility index is near the lowest since March 2022. In the past year, this setup has preceded more intense fluctuations that have tended to accompany dollar strength.
There were six episodes over the past 12 months when the JPMorgan gauge jumped more than a percentage point. The Bloomberg Dollar Spot Index tended to climb into and out of such periods, data compiled by Bloomberg show.
Fed Path
There’s another possible hurdle for dollar bears: If market bets on Fed rate cuts don’t pan out, given stubbornly high inflation.
Price pressures won’t drop back to the Fed’s target any time soon, says Athanasios Vamvakidis, Bank of America Corp.’s head of G-10 currency strategy. That means traders risk being wrong to expect rate cuts so soon and dollar weakness, he said.
“The dollar would remain relatively strong in the meantime,” although it will depreciate on a one- or two-year horizon, he said. “The market is too eager to call this a bearish case for the dollar.”
(Updates market pricing.)
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