US dollar trades in the doldrums as rates and data weigh on outlook

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The US dollar is languishing near one-year lows, in the latest sign of uncertainty gripping Wall Street traders as they brace for the Federal Reserve’s looming interest rate decision.

The US dollar index, which measures the greenback against a basket of six rival currencies, has fallen 3 per cent since the start of August, leaving it teetering just above August’s lows, which were its weakest point in more than a year.

The dollar is sensitive to interest rate expectations as well as predictions about the health of the US economy. It has moved lower in recent weeks as weakening US data has cemented bets that the Fed will loosen monetary policy for the first time since 2020 on Wednesday at the conclusion of the central bank’s September meeting.

Putting more pressure on the greenback, traders have cranked up their expectations in recent days of a 0.5 percentage point interest rate cut — double the size of a more traditional 0.25 percentage point decrease that markets had previously priced in. Any such reduction would knock US borrowing costs down from their current range of 5.25 per cent to 5.5 per cent, a 23-year high.

“Two things have helped drive the dollar lower: bets on the Fed trade and long dollar positioning to begin with, which has been squeezed out,” said Mark McCormick, global head of FX and EM strategy at TD Securities, referring to traders scaling back their bets on a rising US currency.

At the same time, the appreciation of other major currencies has put downward pressure on the dollar, with the yen strengthening past ¥140 to the greenback this week for the first time since July last year. The Japanese currency’s advance underscores increasing divergence between traders’ expectations for US and Japanese monetary policy, with the Fed expected to cut borrowing costs just as the Bank of Japan starts raising its own benchmark lending rate.

The dollar’s recent decline has contrasted with US stocks moving sharply higher, with the benchmark S&P 500 touching a fresh intraday record on Tuesday, highlighting ongoing division among investors across different asset classes about the outlook for the world’s biggest economy.

The dynamic suggests the dollar is focused solely on the fate of the US economy, neglecting bigger and more recent declines in China and Europe, which could ultimately drive global cash stateside, as foreign investors favour better-performing US stocks and traditional safe havens such as the dollar and US Treasury bonds.

“The dollar is priced for a US-only slowdown,” said McCormick. “The dollar is ignoring what is happening in China and what is happening in the eurozone. Just because US equities underperformed for two months doesn’t mean there is a better place to put your money: China and Europe are underperforming.” 

Strategists also noted that the US economy, unlike peers such as Japan, is not particularly reliant on exports, meaning limited implications for US companies with international operations from the dollar’s recent weakness.

“We’re too big and too insular an economy to be impacted by the kind of moves in the dollar that we’ve seen so far,” said Ajay Rajadhyaksha, global chair of research at Barclays.

This all suggests to Karl Schamotta, chief market strategist at Corpay, global payments and foreign exchange risk management firm, that the dollar is poised for a move higher soon.

He pointed to a historical trend in foreign exchange trading referred to as the “dollar smile”, a dynamic that illustrates the US currency’s exceptional role in financial markets: it traditionally performs well both when the US economy is booming and outperforming peers, and when the global economy is in a downturn, and investors seek out the protection of the US currency. 

Still, strategists said dollar pricing may soon flip.

“We’re at the bottom of the smile right now. Global expected growth differentials have narrowed. The US has lost momentum, but it is still doing relatively well,” said Schamotta. “There is an overly crowded trade against the dollar.”

Schamotta pointed to data, including a report from Tuesday morning that showed US retail sales unexpectedly rose in August, a sign of stable consumer spending. He also pointed to the Atlanta Fed’s GDP tracker, which monitors real time expectations for US growth. It currently shows the US GDP is expected to grow 3 per cent year on year in the third quarter. 

“Numbers like retail sales and the Atlanta Fed’s Nowcast are telling us that the US economy is still on a strong footing, despite a deceleration. The only area of weakness is a labour market that has corrected from overheated levels during the pandemic,” said Schamotta.