The dollar is currently experiencing a significant decline, marking its worst slump since November. This decline has led many strategists and investors to believe that a turning point for the world’s primary reserve currency is imminent, with potentially far-reaching consequences for global economies and financial markets.
Several factors contribute to the dollar’s weakening position. Signs of cooling inflation have bolstered expectations that the Federal Reserve will soon halt its interest rate hikes, which has dampened investor confidence in the currency. Moreover, there is a growing belief that rate cuts are inevitable in the future, with market consensus suggesting they may occur in 2024.
Steven Barrow, head of G-10 strategy at Standard Bank, argues that the dollar’s decline will extend over multiple years, attributing it to a shift from the Federal Reserve’s tightening cycle to an easing cycle. He believes that this shift will not only drag the dollar down but also exert downward pressure on other currencies as other central banks also cut rates.
The potential consequences of a prolonged decline in the dollar are significant. Developing nations could benefit from reduced import prices, easing their inflation pressures. Furthermore, currencies such as the yen, which have been tumbling for months, could strengthen, leading to a disruption of popular trading strategies tied to a weaker yen. On a broader scale, a weakened US currency would likely boost American firms’ exports while disadvantaging their counterparts in Europe, Asia, and elsewhere.
The recent 2% decline in the Bloomberg dollar index has contributed to gains in commodities priced in dollars, such as oil and gold. As a result, investors have been eagerly anticipating a downward trend in the dollar, leading fund managers from various institutions to prepare for outperformance in currencies like the yen and those of emerging markets.
Bloomberg strategists suggest that the dollar’s downward trend will persist as long as the real yield curve flattens, as it is a key leading indicator for the currency. However, caution is warranted, as investors have been burned by premature bets on Fed rate cuts in the past, which led to the stabilization of the dollar.
Different experts have varying views on the dollar’s future. Some, like Georgina Taylor of Invesco Asset Management, are not yet ready to reduce their dollar exposure and believe that the battle against inflation is not yet over. Others, such as Michael Cahill of Goldman Sachs, expect a shallower decline in the dollar due to US economic resilience, but acknowledge that the situation could change if the Federal Reserve ceases its fight against inflation while the European Central Bank maintains higher rates.
Valuation measures also support the bearish outlook for the dollar. Its strength, particularly against the yen, has reached levels where the real effective exchange rate indicates that Japan’s currency is trading near its lowest level in decades. Analysts like Paresh Upadhyaya of Amundi Asset Management argue that the dollar is overvalued, citing structural headwinds like the US’s twin deficits (trade and budgetary shortfalls) as well as the dollar smile theory.