Be cautious! The US dollar is heavily surrounded by short interest

The downtrend of the US dollar is accelerating as the market expects the upcoming rate cut by the Federal Reserve to end the dollar's years of strength.

The dollar has dropped 5% from its 2024 high, nearing its one-year low against a basket of major currencies, following a significant decline last month due to the impending rate cut in the United States.

For years, the strong US economy and persistent inflation have kept its interest rates much higher than other developed countries, making dollar-denominated assets more attractive and maintaining its high position after reaching a twenty-year high in 2022.

With inflation cooling off, Federal Reserve Chairman Powell stated last month that the "time has come" for a rate cut, with the market expecting the central bank to cut rates at the September 17-18 policy meeting, eroding this yield advantage.

Brian Rose, Senior Economist at UBS Global Wealth Management, said, "We have always believed that regardless of other circumstances, once the Fed starts cutting rates, the dollar will depreciate, and we still hold this view."

A weaker dollar could make US exporters' products more competitive overseas and reduce the cost for multinational companies to convert foreign profits into dollars. However, the extent of the dollar's long-term decline may depend on the magnitude of the Fed's rate cuts in the coming months and the speed at which other global central banks follow suit.

Currently, the US economy appears stronger than many of its peers. The yield spread between 10-year US Treasuries and German Bunds has narrowed in recent months to around 160 basis points, hovering near the five-year average of 167 basis points.

However, investors are betting on significant future rate cuts by the Fed. Futures tied to the Fed's main policy rate indicate traders expect cuts of around 100 basis points this year, while the ECB is expected to cut rates by around 60 basis points.

CFTC data tracking hedge funds and other speculative investors' positions showed that as of the week ending August 27, investors' net short positions on the dollar reached $8.83 billion, marking the first time in about six months that investors have turned net short. In contrast, net long positions were $32.6 billion in May.

"Powell's recent dovish tone suggests a larger rate cut than initially expected," said Aaron Hurd, Senior Currency Portfolio Manager at Dodge & Cox Global Investment Management, who recently reduced tactical bullish positions on the dollar.

The US government will release the August employment report on September 6, which may provide clues on whether the still healthy job market, as many policymakers have described, is deteriorating further.

At least in the short term, several factors may prevent further decline of the dollar. During the August selloff, the dollar index fell by 2.2%, leading some strategists to conclude that the dollar may have fallen too quickly.

"While the Fed's long-term actions in September do imply a weaker dollar in the fourth quarter, the recent trend we've seen is a bit of an overreaction," said Helen Given, Co-Head of Trading at Monex USA However, Monex USA expects the euro to reach 1.13 against the US dollar by June 2025, implying a depreciation of about 2% for the dollar. Rose from UBS has a similar outlook on this currency pair.

Many are waiting for more evidence of a slowdown in the US economy before taking a more negative view on the dollar.

"The economy is slowing down, but it is still in a very healthy state," said Thanos Bardas, Co-Head of Global Investment Grade Fixed Income at Neuberger Berman.

Investors also believe that the outcome of the US presidential election in November could impact the fate of the currency. The latest polls show intense competition between Republican presidential candidate Trump and Democratic presidential candidate Harris.

Trump has been criticizing the strength of the dollar, claiming it damages America's competitiveness. However, Bardas mentioned that many of his policies, such as tariffs and tax cuts, could strengthen the dollar.

Steven Englander, Global Head of G10 FX Research at Standard Chartered, wrote at the end of last month that a Harris victory could lead to higher taxes, potentially putting greater pressure on the Fed to cut rates if economic activity slows down.

Kit Juckes, a strategist at BNP Paribas, stated that ultimately, the market's reaction to Fed rate cuts could be a key factor in determining the direction of the dollar. He wrote:

"The strong US growth has left foreign investors perpetually unsatisfied, matched by foreign investors eager for returns. Now, with economic growth slowing and interest rates falling, we will wait and see."