As the Federal Reserve's policy meeting approaches next week, uncertainty surrounding U.S. policy is suppressing the dollar's exchange rate, setting it up for its worst weekly performance since June.
The Bloomberg Dollar Spot Index fell to a three-week low on Friday, with a weekly decline of 0.9%, marking its largest drop in nearly seven months. Options traders are now paying a premium to hedge against the risk of further dollar depreciation over the next month—a stark contrast to the market sentiment just a week ago, when bullishness on the dollar had surged to its highest level since November.
Investor sentiment has been on a roller coaster this week. U.S. President Donald Trump first threatened tariffs on Europe, citing his ambition to acquire Greenland; he then abruptly abandoned the tariff threat after reaching an agreement with NATO Secretary General Mark Rutte during the World Economic Forum in Davos. Notably, despite market bets that the resilience of the U.S. economy would lead the Fed to hold rates steady, thereby pushing U.S. Treasury yields higher, the dollar's exchange rate still declined. This indicates that, for the dollar, political risk has become a more significant influencing factor than monetary policy.
"At the moment, the distribution of potential dollar returns by 2026 is almost certainly skewed heavily to the downside," wrote Brent Donnelly, President of Spectra Markets and a former forex trader, in a report. "The world is slowly realizing that U.S. policy chaos is far from over."
The money market is pricing in two 25-basis-point interest rate cuts by the Fed this year, while seeing almost no chance of a rate adjustment being announced at next week's meeting. The one-week volatility measure, reflecting the Fed's policy decision on January 28, climbed to a more than one-month high on Thursday before edging lower on Friday.
Concerns about the Fed's independence, coupled with expectations that a potential successor to Chairman Jerome Powell might yield to pressure from Trump and accelerate the pace of rate cuts, are also weighing on the dollar.
Trump stated that he has completed interviews with candidates for the Fed chair position and reiterated that he already has a suitable candidate in mind. Previously, Trump had repeatedly criticized Powell for being too slow to cut interest rates.
"With rising policy volatility, the dollar has become a 'release valve' for U.S. risk premium," said Erika Camilleri, Senior Global Macro Analyst at Manulife Investment Management. "This also explains why the dollar experienced a sharp downturn this week, even as markets scaled back their expectations for the extent of Fed rate cuts."
Bearish sentiment towards the dollar is intensifying. Data released Thursday by the Bureau of Economic Analysis at the U.S. Commerce Department showed that the revised annualized growth rate for the third quarter was 4.4%, the fastest pace in two years. The latest data from the U.S. Labor Department indicated that after holiday-related fluctuations, the number of Americans filing first-time claims for unemployment benefits stabilized last week, remaining at a low level. In the week ending January 17, initial jobless claims increased by 1,000 to 200,000, compared to a median forecast of 209,000 from economists surveyed by Bloomberg.
"The optimistic performance of the U.S. labor market has not yet posed a threat to our moderately bearish view on the dollar," said Pat Locke, a foreign exchange strategist at JPMorgan in New York. "In the coming weeks, U.S. policy event risks are also generally tilted towards being negative for the dollar."
The Bloomberg Dollar Spot Index rose to its 200-day moving average last week before retreating. Since April of this year, this moving average has been a significant resistance level hindering any substantial rebound in the dollar. The index briefly surpassed this average in November of last year and again in early January of this year, but on both occasions, it subsequently resumed its downward trend.
Views from Bloomberg Strategists. "The synchronized decline of the dollar and U.S. stocks earlier this week serves as a reminder that the dollar may no longer be acting as a 'shock absorber' for the equity market. The three-month correlation between the Bloomberg Dollar Spot Index and the S&P 500 Index has once again nearly returned to zero—this implies a reduction in the hedging protection offered by portfolios, necessitating higher hedge ratios. The emergence of attractive investment alternatives in overseas markets, combined with the renewed use of tariffs as a coercive tool, could reactivate the very same forces that led to the dollar's significant decline last year." — Tatyana Darie, Macro Strategist, Market Live Analysis Team
Benefiting from Trump's policy reversal regarding the Greenland-related tariffs, risk-sensitive currencies among the G10 group outperformed others this week. Over the past five trading days, the New Zealand dollar, Norwegian krone, and Australian dollar led the gains against the U.S. dollar, while the Japanese yen lagged behind its G10 peers.
Comments