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A rally in the US dollar this year has gone into reverse as investors bet that falling inflation in the world’s largest economy will give the Federal Reserve more room to cut interest rates.
The greenback, which had gained as much as 5 per cent this year by mid-April against a basket of currencies, is now on track for its first down month of 2024 after the rate of consumer price inflation eased in line with forecasts on Wednesday.
The reading, after months of higher than expected inflation, has helped allay fears that the Fed may not be able to cut rates much this year, or may even have to raise them again from a 23-year high to control price growth.
“Fed pricing matters more than anything else in markets at the moment,” said Athanasios Vamvakidis, head of G10 foreign exchange strategy at Bank of America.
“The inflation data this week meant another rate hike is off the table . . . now it’s just a matter of time until they start cutting,” he added.
Investors had a major rethink on the path of interest rate this year as US inflation rose in both February and March. That helped lead traders to drastically reduce bets on rate cuts, while hedge funds tore up their bearish bets against a resurgent dollar.
But after Wednesday’s reading showed a fall in inflation to 3.4 per cent, traders have raised their wagers on the Fed delivering two quarter-point rate cuts this year.
The dollar suffered its worst day of the year on Wednesday. Despite a partial rebound later in the week, it is still down 1.4 per cent this month.
Analysts say the recent softening of US data, which started early this month when a critical jobs report undershot expectations, could be the start of a sustained period of dollar weakening, although given the economy is still relatively robust any declines could take time.
“I think we are at a turning point but we are going to faff around here for some indeterminate period of time,” said Kit Juckes, a foreign exchange strategist at Société Générale. “The dollar bull is running short of arguments for the next leg higher.”
The dollar has weakened alongside a fall in US government borrowing costs, which has helped drive stock markets in the US, Germany and the UK to record highs this week.
The benchmark 10-year US Treasury yield — a key driver of asset prices across the globe — has fallen to 4.3 per cent, having reached 4.7 per cent late last month, as traders have raised bets on more than one Fed rate cut this year. Yields fall as prices rise.
This month’s dollar weakening follows a recent build-up of bets against the currency among hedge funds, which started selling the currency last month and have become “firmly short”, according to Sam Hewson, head of foreign exchange sales at Citigroup.
Asset managers, however, maintain their overweight positions, Hewson said. When their positioning differs from hedge funds, “historical patterns suggest . . . it is best to be short” the dollar, he added.
The recent moves come as welcome news to central bankers around the world, who have been struggling to deal with rising US Treasury yields and the dollar’s persistent strength. That has particularly been the case in Japan, where the ministry of finance is thought to have sold around $59bn of dollars in recent weeks to support its ailing currency.
“A weaker dollar makes life a little bit easier for Tokyo,” said Chris Turner, a currency strategist at ING, pointing out that the Japanese currency is more sensitive to shifts in US rate expectations than to rising borrowing costs in its own market.
The evaporation of expectations for a possible US rate rise could also increase room for manoeuvre at the European Central Bank which is widely expected to start cutting interest rates in June.
ECB President Christine Lagarde has been clear that Europe can start lowering borrowing costs ahead of the Fed. But if the US central bank were to raise rates again this year while rates come down in Europe, that could put the bloc’s currency under significant pressure and risk stoking inflation.
“The latest US data is good news for the ECB,” said BofA’s Vamvakidis. “It means the ECB can cut in June without being too concerned the euro would weaken.”
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