Traders are closely monitoring the relative economic strength and interest rate policies of global central banks to navigate a falling U.S. dollar backdrop. The U.S. dollar index, which measures the currency against a basket of other currencies, fell 4.8% in the third quarter of 2024, marking its worst quarterly performance in almost two years. The drop followed a significant 50 basis point rate cut by the Federal Reserve last month, the first reduction since 2020.
Yields have been a major factor in valuing currencies, and with the Fed and other central banks lowering interest rates to support economic growth, the yield gap between the U.S. and others country should shrink. Therefore, traders are positioning against the dollar in favor of currencies that could see their yield differentials narrow.
Net short dollar positions increased to $14.1 billion in futures markets, reaching a peak not seen in about a year. Despite this bearish sentiment, the strong U.S. economy could limit the Fed’s rate cuts, potentially complicating the dollar’s downward trajectory. Additionally, the upcoming US presidential election on November 5 introduces uncertainty that could impact foreign exchange markets.
The dollar index has remained stable since the start of the year, but has fallen about 5% from its April peak. The dollar weakened against several developed market currencies as U.S. yields fell in anticipation of Fed policy easing.
Upcoming economic data, including euro zone inflation figures for September and US labor market data to be released on Friday, could influence currency movements. Although futures markets are pricing in another 70 basis points of rate cuts, strong economic indicators could argue for less aggressive easing.
Currency strategists focus on individual stories, such as interest rate differentials resulting from divergent monetary policies. For example, Norway’s central bank kept its key interest rate at a 16-year high, while Australia’s central bank kept rates steady, signaling that no cuts are expected in the near future. Brazil, on the other hand, raised rates last month to deal with inflation, with the Brazilian real down about 10% against the dollar this year.
The Japanese yen, supported by the Bank of Japan’s rate increase to 0.25% in July, saw a 13% rally from its 2024 lows against the dollar. Meanwhile, a BofA Global Research study last month identified the yen and Norwegian krone as some of the most undervalued currencies in the developed world, with the dollar and Swiss franc the most overvalued.
Investors are also bracing for potential volatility due to the U.S. presidential election, with some speculating that a victory by Republican candidate Donald Trump could strengthen the dollar. However, the election outcome remains an important variable in foreign exchange forecasts.
Reuters contributed to this article.
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