Currency Insight : Dramatic decline in dollar – Moneycontrol

Navneet Damani

The US Dollar Index over the last couple of months has weakened sharply against its major crosses and has had a dramatic decline following the expectation of bigger and bloating stimulus package, lower interest rates and expansion of Fed balance sheet. We had mentioned that the greenback will continue to remain under pressure and could test levels of 93, which has been achieved as it made a low of 92.11.

The larger question now is: will the sell-off continue, forces leading to the fall still persist, and what’s next for the dollar.

Stimulus saga

US President Donald Trump along with Treasury Secretary Steven Mnuchin has consistently mentioned that another $1 trillion of stimulus package is needed to support the economy.

Earlier this month, the US President signed executive orders that partly restored enhanced unemployment payments to the tens of millions of Americans who lost jobs in the coronavirus pandemic. Negotiations broke down between the White House and top Democrats in Congress over how best to help Americans cope with the heavy human and economic toll of the crisis.

The Democratic-majority House of Representatives passed a coronavirus support package in May which the Republican-led Senate ignored. Democratic presidential candidate Joe Biden called the orders a “series of half-baked measures” and accused Trump of putting Social Security “at grave risk” by delaying the collection of payroll taxes that pay for the programme.

Trump also suspended collection of payroll taxes, which pay for Social Security and other federal programmes, an idea that he has repeatedly raised, but has been rejected by both parties in Congress. The suspension would apply to people making less than $100,000 per year.

At present, most market participants are focusing on cyclical factors blaming scaled-back expectations for US growth, lower interest rates and the rapid expansion of the Federal Reserve’s balance sheet.

Collapsing yields

Yields have collapsed in the US relative to the Euro Zone, reflecting the Federal Reserve’s move to slash interest rates to near zero in the face of the COVID-19 pandemic. The European Central Bank (ECB), which had already slashed interest rates below zero, had very less space to manoeuvre given its benchmark rates were already in negative and investor bets that Europe’s economic outlook is brighter. This shift in yields has driven the dollar lower, by reducing the attractiveness of dollar assets, to predict a further depreciation of the dollar from here would require yet greater declines in yields, as prices push higher still. Rate differentials are likely to stay compressed but steady for many months.

Another factor that market participants are keenly watching is the real yields – adjusted for inflation that has fallen into negative and at record low levels. But the dollar is far from alone in offering negative real yields. The euro and sterling have been doing so for many years, often with very little attention from markets, so it is not clear why this should now be seen as such a problem for the dollar. And for real yields to fall further, nominal yields would need to keep declining or inflation would have to pick up.

For the latter to occur, there would need to be stronger US growth. So selling the dollar on lower real yields means selling the currency on expectations of a more robust recovery. This simply does not make sense.

The dollar might have been languishing for the past few months, but there is plenty of life in the old dog yet. Investors looking for further weakness, based purely on an extrapolation of recent trends, may end up chasing their own tails.

Dollar CFTC positioning

The dollar index in this year has corrected by over 10.5 percent, and in the below chart we can see that after a sharp price correction and reduction in large speculators positions (green line below) there has been a turnaround witnessed in prices.

In the chart we have highlighted three instances, Line 1 we can see that large speculators position has trimmed significantly and are near the zero line after which there has been over 10 percent seen in the dollar index. In the second instance also large speculators did not add significant long positions and after consolidating for some time a similar 10 percent move was witnessed.

At present also large speculators positions is near zero line and from here we expect that the dollar index could either get into consolidation or start a fresh leg of rally on the upside. This is just an observation of historical patterns and not a recommendation to go long immediately. We expect that momentum on the down side could get restricted from current levels and one must cover their shorts if there are any.

Outlook

The dollar index has completed its first target of 93 mentioned in the previous report, and it seems that the FOMC minutes have provided the much needed support to the dollar.

In the latest FOMC meeting minutes a number of participants noted that providing greater clarity regarding the likely path of the target range for the federal funds rate would be appropriate at some point. Officials again sounded unenthusiastic about capping Treasury yields – a strategy known as yield-curve control – an impression that hurt Treasuries and lifted yields to session-highs. From the current levels a dovish outlook for policy rates is likely to keep gains capped, but at the same time we also expect that pace of selling could get slow. So it means that either the dollar index could start to consolidate or could start a fresh leg of rally.

We expect that the dollar index from here could test level of 95 and a break above that could take it higher towards 96.50. On the down immediate support is at 91.5 and break below which the next support is at 88.50 level.