Dollar Reverses Course: Who Wins and Who Loses?

In the foreign exchange market, where daily trading volumes reach a staggering $9.6 trillion, shorting the US dollar had been a prevailing strategy this year. However, this bet is beginning to falter as the dollar, a key global reserve currency, has risen to nearly a two-month high despite the ongoing US government shutdown.

Shifting Hedge Fund Positions

Traders in Asia and Europe indicate that hedge funds are increasing options bets, anticipating the dollar's rebound against most major currencies to continue through the year-end. This shift is largely attributed to overseas market dynamics, with the euro and Japanese yen experiencing significant declines this month. Additionally, calls from Federal Reserve officials for caution on further rate cuts have boosted the dollar's appeal.

Potential Economic Repercussions

The longer the dollar's strength persists, the greater the losses for investors clinging to expectations of its decline. This bearish camp includes giants like Goldman Sachs Group, JPMorgan Chase, and Morgan Stanley. Should this trend continue, it could have far-reaching global economic consequences, such as making it harder for other central banks to implement easing monetary policies, driving up commodity costs, and increasing the burden of dollar-denominated foreign debt.

Strategic Adjustments

Ed Al-Hussainy of Columbia Threadneedle, formerly a dollar bear, has now shifted his stance. The portfolio manager, who shorted the dollar following the US elections at the end of 2024, has gradually adjusted his position by reducing emerging market exposure. He attributes this change primarily to the market overestimating the Fed's rate-cut expectations given the resilience of the US economy.

Market Dynamics and Future Outlook

After experiencing its steepest first-half decline in decades, the Bloomberg Dollar Spot Index has risen by approximately 2% since mid-year. The latest data from the Commodity Futures Trading Commission (CFTC) revealed that as of the end of September, hedge funds, asset managers, and commodity trading advisors still held net short positions on the dollar. While these positions are considerably smaller than their mid-year peak, these investors could face substantial losses if the dollar continues to appreciate.

Key Factors Determining the Dollar's Trajectory

Of course, the dollar's future trajectory remains uncertain, and the Federal Reserve's next move will play a pivotal role. Traders currently anticipate two 25-basis-point rate cuts by the Fed before the end of the year, with further cuts expected next year. However, recent minutes from the Fed's September meeting and policymakers' comments suggest this rate-cut path is far from guaranteed.

Expert Analysis

"The market has now priced in a full Fed rate-cut cycle," says Mona Mahajan, investment strategist at Edward Jones. "The market wasn’t pricing that in previously, which explains why the dollar has weakened so much, but some mean reversion in currency rates is warranted." Considering the situation in France and expectations of looser fiscal and monetary policies in Japan, the dollar's gains against the euro and Japanese yen may prove sustainable. As Andrew Brenner, vice chairman at Natalliance Securities in New York, puts it, "Given the pressure on both the yen and the euro, don't expect the dollar to weaken significantly."

Additional factors that could influence the dollar:

• Global risk sentiment: Heightened geopolitical tensions or economic uncertainty could drive investors to the safe-haven dollar.
• Inflation data: Stronger-than-expected inflation data could prompt the Fed to maintain its hawkish stance, further supporting the dollar.
• Relative economic performance: If the US economy continues to outperform other major economies, the dollar is likely to remain strong.