FX: Dollar index falls below the 100 mark

     For Stephen Jen, a former IMF economist who famously invented the dollar smile theory, the US Federal Reserve looks ready to win the inflation war without plunging the US into a deep recession. That is bad news for the dollar, the world's dominant reserve currency, and the risk of a collapseforeign exchange marketIt set off layers of ripples...

　　According to his "Dollar Smile Theory", the dollar usually rises when the US economy is in a deep recession or strong expansion, but lags during periods of moderate growth such as now. And that is certainly happening now!

　　After plunging more than 100 points in the previous trading day to refresh nearly 15-month lows, the U.S. dollar index continued its recent sharp depreciation on Thursday (July 13): it fell below the all-important 100 mark after entering the New York session, and the latest trading in Asian markets on Friday morning was around 99.80.

　　A set of statistics showed that the dollar index fell for the sixth consecutive day overnight, setting a record for the longest consecutive day of decline since July 2020, during which the decline reached 4.5% - the largest six-day decline since November 2022.

　　In addition to refreshing the nearly 15-month low, the dollar index has actually fallen to the level of the early epidemic in 2020.Whether it is the crazy rally under the radical tightening cycle last year or the violent turmoil in the foreign exchange market at the beginning of the epidemic, it seems that it has now become a thing of the past.

　　Why did the dollar's decline suddenly become "irreducible"?

　　Jen said,With the dollar falling to its lowest point in more than a year, evidence for a weaker dollar in the "dollar smile theory" has formed,Traders are betting that consumer prices have peaked following the Federal Reserve's aggressive policy tightening and that the dollar's decline will continue as the burden of public debt and economic imbalances weigh on growth.

　　"The dollar has been and remains massively overvalued. The dollar will return to its fair value very soon," he said in an interview. "I think the Fed will have one more rate hike and a soft landing. Once the FOMC's collective view on inflation changes, which I think will happen very soon, the dollar will weaken at a faster pace and the dollar will no longer have cyclical support."

　　The reaction to Wednesday's sharp drop in US CPI data to the "3 era" seemed to justify the foreign exchange industry's long-term bearish call on the dollar this year.The U.S. Bureau of Labor Statistics released on Wednesday that the year-on-year increase in the overall CPI in June fell to 3.0%, and the year-on-year increase in the core CPI excluding food and energy also fell back to 4.8%, the smallest increase since late 2021.

　　On Thursday, there was still good news on the inflation front. The US Department of Labor announced that the year-on-year growth rate of the US PPI in June slowed sharply to 0.1% from 1.1% last month, lower than the expected 0.4%, setting a new low since August 2020. The month-on-month growth rate also fell back to 0.1%, lower than the expected 0.2%, and the previous value was revised from -0.3% to -0.4%.

　　Economists watch producer prices closely because they are a leading indicator of consumer prices, and companies have traditionally passed on higher costs to customers.

　　"Wednesday's CPI data adds weight to the view that the Fed tightening cycle is nearing an end," said Bipan Rai, global head of FX strategy at Canadian Imperial Bank of Commerce. "By contrast, the interest rate path of several other major global central banks is not certain to end so soon, which is a strong signal of dollar weakness."

　　As the chart below shows, traders in the interest rate market are already pricing in very little for the Federal Reserve to raise interest rates twice more this year, and the market generally believes that the Federal Reserve is about to usher in the "final chapter" of interest rate hikes this month.

　　Jen also said that all of this means investors will have to deal with a U.S. macro headwind other than inflation or a potential recession: the deficit.

　　As the US has ramped up spending, public debt has risen to 118 per cent of gross domestic product from 54 per cent in 2000, according to the St Louis Fed. The US's current account deficit, the gap between saving and investment, has worsened. That means the US already has a huge net debt to the rest of the world and, at least in theory, its currency is vulnerable to a sell-off if foreign investors dump dollar assets.

　　That argument was also backed up by Paresh Upadhyaya, director of currency strategy at Orient Asset Management. "If you stop seeing high-quality inflows into Treasuries, how do you finance those deficits? The dollar has to depreciate enough to attract investors," said Mr. Upadhyaya.

　　Alan Ruskin, chief international strategist at Deutsche Bank, points out that a "slowing US economy without a deep recession" is the worst that dollar bulls fear, because risk trading is possible in this scenario - bonds will like it, stocks will like it, but the dollar really doesn't like it.

　　Industry cries out: All currencies will rise against the dollar

　　After the release of the CPI report this Wednesday,Goldman Sachs(328.68, 2.28, 0.70%)The group has also joined the growing dollar-bearish camp.Goldman Sachs said the dollar would continue to depreciate at a moderate pace, which would boost currencies hit by the Fed's aggressive tightening - from emerging market currencies to the Swedish krona to the Japanese yen.

　　Goldman Sachs analysts Michael Cahill, Isabella Rosenberg and Teresa Alves wrote in a note on Thursday that "the dollar has suffered a sharp sell-off on the back of cooling inflation and expectations that the Fed will take a more patient stance after July. We think this is likely to continue as the same factors that weighed on yesterday's CPI report are likely to be weaker in the coming months."

　　Goldman Sachs analysts said the upside risks to the dollar have eased, providing an opportunity for those who still need to contend with domestic challengesQualcomm(123.12, 4.44, 3.74%)An inflationary, contractionary G10 currency offers a clearer case for going long: "Sterling is our first choice and the Norwegian krone should do well."

　　In fact, the sharp changes in the dollar's exchange rate in recent days have had a profound impact on global currency markets. This week, the Swiss franc rose to its highest level since 2015, while the euro and the pound also rose to their highest levels in more than a year.

　　A set of comparisons shows that the dollar has fallen against all G10 currencies over the past month.

　　A number of shrewd institutional investors may also have laid the groundwork for today's situation recently. According to data from the US Commodity Futures Trading Commission (CFTC), hedge funds became net sellers of the dollar for the first time since March last week.Many fund giants even chanted that all currencies against the dollar would rise.

　　Brad Gibson, co-head of Asia-Pacific fixed income at Alliance Bernstein, said: "Overall, we think the dollar may have peaked and there may be room for other currencies to perform better between the second half of 2023 and 2024." He said this was because the US economy would slow and the Federal Reserve could start easing.

　　Jim Leaviss, chief investment officer for public fixed income at M & G Investments, who is shorting the dollar against the yen, said: "There are a lot of opportunities in the currency market right now and a lot of emerging market currencies look cheap."

　　In addition,UBS(21.14, 0.45, 2.17%)Shamaila Khan, head of emerging markets and Asia Pacific fixed income at Assets, said Latin America currencies including Brazil, Mexico, Chile and Colombia, all of which have strengthened against the dollar this year, with the Colombian peso up 18 per cent.

　　"We like these Latin American currencies because they offer high yields - double-digit spreads and we expect the dollar to weaken in the second half," Mr. Khan said.