Investors dump dollar in bet that US rates have peaked

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Investors are selling dollars at the fastest rate in a year as they raise their bets that the US Federal Reserve has finished its aggressive campaign of interest rate increases and will deliver multiple cuts next year.

Asset managers are on track to sell 1.6 per cent of their open dollar positions this month, the largest monthly outflow since last November, according to State Street, which is custodian to $40tn of assets. Managers had made “significant” sales every day since weaker-than-expected US jobs data on November 3, according to the bank.

That has helped put the greenback on course for its worst monthly performance in a year, with analysts warning that sales by asset managers could just be the start of a longer-term trend among investors to reduce exposure to US assets.

“Flows in the past two weeks point to a rapid rethink with dollar demand,” said Michael Metcalfe, head of macro strategy at State Street, adding that recent sales marked the unravelling of “an unusually large US [dollar] overweight” position.

“Investors think ‘if [rate cuts are] actually going to be delivered then I don’t need to hold as many dollars’.”

There have only been six such rapid unwinds of dollar holdings in the past two decades, according to State Street. The most recent of these happened in November last year, when the dollar index — a measure of its strength against a basket of six currencies — went on to weaken by around 10 per cent by the end of January.

Metcalfe added that, despite the recent unwind, asset managers were still overweight dollars compared with other currencies, a sign that dollar weakness could have further to run. 

The greenback enjoyed a huge bull run last year, driven by the Fed’s rate rises. The dollar index had risen by as much as 19 per cent by late September, delivering large profits to macro hedge funds with bullish positions, before weakening sharply in the fourth quarter.

This year it surged by more than 7 per cent between July and October as robust economic data pushed benchmark US borrowing costs to a 16-year high and convinced investors that rates would stay higher for longer.

But the narrative has changed again in recent weeks. US inflation fell by more than expected in October to 3.2 per cent, prompting investors to price out any prospect of further rate rises. Recent weakness has left the dollar index roughly where it started this year and futures markets are now pricing more than 0.5 percentage points of Fed rate cuts by September next year.

Geoff Yu, foreign exchange strategist at BNY Mellon, custodian to $46tn of assets, said that over the past 20 days the firm’s custody clients “have been selling dollars at the fastest pace this year”, with a preference for buying the Japanese yen, Canadian dollar and a range of Latin American currencies.

Selling pressure on the dollar will come as welcome news for Japan’s finance ministry. It has been on red alert for a possible currency intervention as the yen traded close to a 33-year low against the greenback earlier this month, adding to inflationary pressures by pushing up the cost of imported goods.

While the yen has fallen by around 12 per cent against the dollar this year, November has offered some reprieve with the currency strengthening by around 1.5 per cent.

Yu expects yen strength to continue, with the Bank of Japan widely expected to drop its negative interest rate policy in the coming months. “There’s not much point in being short the yen [betting on a falling price] as every Bank of Japan policy meeting will be a live event,” he said.

Dollar weakness also comes as a relief for emerging markets. It makes it easier for them to repay dollar-denominated borrowings and could start to lure investors back into developing economies after heavy sales of hard-currency debt this year. 

“We are overweight emerging market equities and overweight commodities,” said Florian Ielpo, head of macro, multi-asset at Lombard Odier Investment Managers, adding that the weaker dollar environment was “unravelling some of the very tight [bullish] case for US equities”.

MSCI’s emerging market stocks index has added 3 per cent so far this year, well behind a rise of almost 19 per cent for the US S&P 500 index of blue-chip stocks.

Francesco Sandrini, head of multi-asset strategies at Amundi, said heading into 2024 he expected dollar weakness to continue “in part because we anticipate less turbulence between the US and China”, meaning investors had less need of the greenback as a safe haven. 

However, he added that, since the start of the Russia-Ukraine war, “something is broken” in the usual rotation between developed and emerging markets, noting that a preference for equities in Mexico and Brazil was partly down to a perception that these countries are well placed politically.

“We are seeing a lot of interest in emerging markets — but I think that these two forces, the weaker dollar and geopolitical concerns, are a little in conflict,” he said.