The USD tends to appreciate strongly when risk aversion is high or when the US economy is outperforming. Neither condition is currently in place. China’s growth concerns have temporarily receded and commodity prices are rallying. And with a cautious Fed and accmmodative central banks elsewhere, market conditions have turned more benign, leading to a reversal of the safe haven demand for USD assets.
The April FOMC statement is unlikely to be a catalyst to reignite a dollar uptrend. It would likely fall short of saying risks are “nearly balanced,” and as a result, will likely cause many investors to conclude that a second rate increase before September is possible, but unlikely
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Could the USD fall further if the FOMC statement turns out to be uneventful as we expect? It is possible, but we think the downside should be more limited from here.
First, CFTC data indicate that speculative USD long positions have been pared back significantly from around 25% of open interests in November to about 3.2% currently, although if we exclude the JPY, the drop is comparatively less. Given relatively positive labor market fundamentals in the US economy, we doubt that USD positioning will turn to net short in the near term.
Second, as our asset allocation strategist points out, the US dollar is likely very close to a bottom, if history is any guide. The trade-weighted dollar has already fallen more than 7% . versus the majors since the January peak, compared to the largest peak-to-trough drawdown in a USD uptrend of 9.5% (Figure 1).
Finally, Fed rate hikes expectations are already quite low, in our view, with less than 20% probability of a 25bp hike priced for June and around 60% priced for December.
Although we expect benign market conditions and a range-bound USD in the near term, there are risks on the horizon that could potentially interrupt the risk recovery. In particular, financial risks in China appear to be rising. Chinese SOE defaults in the onshore bond market have driven credit spreads wider, in turn leading to renewed pressure on the stock market. Consequently, roughly RMB60bn of onshore bond issuance was cancelled or postponed, while reported defaults in the shadow banking sector have increased. If the contagion effect widens beyond China’s shores, safe haven demand for the USD could return.