Author: Saqib Iqbal Ahmed

NEW YORK (Reuters) – Traders wondering how to take advantage of further declines in the U.S. dollar are paying attention to the relative strength of economies around the world as interest rate changes from global central banks shake currency markets.

It fell 4.8% against a basket of currencies in the third quarter, its worst quarterly result in almost two years. Pressure on the U.S. currency increased after the Fed made a massive 50 basis point cut last month, the first cut since 2020.

How much the dollar falls further and which currencies benefit may depend largely on yields. For years, U.S. profitability has outperformed most advanced economies, strengthening the dollar’s attractiveness relative to other currencies.

This picture is changing as the Fed and most other central banks lower interest rates to protect economic growth. Many traders who bet against the dollar do so through currencies whose yield differential with the dollar is expected to narrow.

Net bets on a weaker dollar rose to $14.1 billion in futures markets, the highest level in about a year, according to data from the Commodity Futures Trading Commission. However, the downward path for the dollar is likely to be bumpy.

The relatively powerful U.S. economy could limit the scope of Fed rate cuts, complicating the prospects for further declines in the dollar. Meanwhile, the US presidential election and geopolitical concerns threaten to bring further volatility to currency markets in the coming weeks.

“You don’t just sell a dollar and buy everything,” said Jack McIntyre, portfolio manager at Brandywine Global. “You have to be a little more selective.”

While the currency is little changed on the year, it is down around 5% from its April high, with the currency falling against several other developed market currencies as US yields fall in anticipation of monetary easing. by the Fed.

Some of the risks to a weaker dollar have become more apparent in recent days.

The dollar rose sharply against the British pound on Thursday after the Bank of England said it may cut interest rates more aggressively if inflation pressures continue to ease.

A day earlier, data showed euro zone inflation fell below 2% in September for the first time since mid-2021, strengthening the case for the European Central Bank to cut interest rates this month, a potential source of euro weakness.

The dollar’s role as a unthreatening haven has also been highlighted as tensions in the Middle East have escalated in recent days.

On the American side, Friday’s labor market data may assist shape views on how much the Fed can cut interest rates for the rest of the year.

While futures markets show an additional 68 basis points of reductions, the vast number could strengthen the case for more moderate policy easing. However, “if we enter a period of mild change in the U.S. economy, the market will discount more curve cuts, which will weaken the dollar,” said Christian Dery, head of macro strategy at Capital Fund Management.

Nevertheless, investors believe the dollar still has further declines in some corners of the market.

Paresh Upadhyaya, director of fixed income and FX strategy at Amundi US, said he was looking for “specific stories such as widening interest rate differentials due to monetary policy divergences.”

His plays in the weaker dollar include positions in the Norwegian krone and Australian dollar. Norway’s central bank recently kept its key interest rates at a 16-year high, signaling that any cuts would have to wait until early 2025. Australia’s central bank kept interest rates steady last week and said interest rate cuts in the near future future are unlikely.

Upadhyaya also added his position in the Brazilian real world. Unlike many other institutions, Brazil’s central bank raised interest rates last month in a bid to address a arduous inflation outlook. The Brazilian real has lost about 10% against the dollar this year.

Investors say the Japanese yen may also find further support from diverging central bank policies. The Bank of Japan raised interest rates to 0.25% in July, a landmark departure from a decade-long stimulus program aimed at boosting economic growth.

While the Bank of Japan has signaled it is in no rush to raise interest rates further, the narrowing gap between Japanese and U.S. interest rates has already pushed the yen up 10 percent from its 2024 low against the dollar. CFTC data showed net upside bets on the currency against the dollar at $5.8 billion.

“As global central banks also begin to cut interest rates, currencies like (the yen) will see the biggest gains against the dollar,” said Natsumi Matsuba, director of currency trading and portfolio management at Russell Investments.

An analysis of currency valuations based on metrics such as purchasing power parity and real effective exchange rates, published last month by BofA Global Research, found that the yen and Norwegian krone are among the most undervalued currencies in developed countries. The study found that the dollar and the Swiss franc are the two most overvalued currencies.

Regardless of their position, however, investors also face potential volatility around the November 5 U.S. presidential election.

The uncertainty in the weeks before the vote may drive investors seeking safety to the dollar. Many investors also believe that the victory of Republican candidate Donald Trump may strengthen the dollar.

“The wild card in any forecast for our currency right now is the U.S. election,” said Brandywine’s McIntyre, who remains bearish on the U.S. dollar but less so than before the currency’s recent decline. “That’s why it’s hard to be super convicted.”