Why has the US dollar regained strength? Despite expectations of a weakening dollar, it has experienced a 2% rebound over the past month, perplexing investors & forex traders alike.
There are several factors contributing to this phenomenon. One significant factor is the growing concerns surrounding the US debt ceiling negotiations, the stability of banks, and the global economic outlook. These worries have enhanced the perception of the dollar as a safe-haven asset.
Additionally, there are indications that the Federal Reserve might need to raise interest rates once again. Technical factors related to investor positioning also play a role in the dollar's resurgence.
The dollar index, which measures the currency against six others, has climbed approximately 2% since mid-April to around 103. However, it remains around 10% lower than its peak of 114.78 in September of the previous year.
Analysts currently attribute the recent strengthening of the dollar to concerns over the debt ceiling issue. Although Democrats and Republicans are getting closer to reaching an agreement to raise the borrowing limit of $31.4 trillion, the potential risk of a disastrous US debt default lingers, especially given the perceived weakness of many banks. During periods of apprehension, investors tend to seek out less risky assets such as bonds, gold, and the US dollar.
Esther Reichelt, a currency strategist at Commerzbank, highlights the increased demand for the dollar due to "unknown unknowns" and questions the severity of vulnerabilities in US regional banks and the potential consequences of an escalation in the debt ceiling conflict.
The global economic growth outlook and recent data indicating underperformance by the Chinese economy in April have also contributed to the purchase of safe-haven assets, including the US dollar.
Alvin Tan, the head of Asia FX strategy at RBC Capital Markets, challenges the safe-haven argument, pointing out that if investors were genuinely concerned, stock prices would be declining. However, the S&P 500 index has remained relatively flat since mid-April and has even increased by over 8% this year.
Tan suggests that concerns regarding the Federal Reserve's ability to control inflation are part of the explanation. The University of Michigan's recent survey showed that consumer inflation expectations reached a five-year high of 3.2% in May, leading to higher bond yields and a stronger dollar.
While traders currently anticipate a substantial interest rate cut by the US central bank later this year due to an impending recession, Tan remains sceptical. He believes there is a possibility that US interest rates could rise instead, contradicting the notion that the dollar's decline will be continuous.
Other analysts attribute the dollar's resurgence to technical factors. Investors have taken substantial short positions against the dollar. Last week, hedge funds and other speculators had net short bets totalling $14.56 billion, the largest such position since mid-2021. Paradoxically, this positioning can contribute to upward rallies. When the dollar rises even slightly, some traders are compelled to close their short positions by purchasing the dollar, thereby boosting its value.
Chester Ntonifor, an FX strategist at BCA Research, suggests that the dollar has been excessively oversold, which serves as a technical indicator for its potential rebound. Furthermore, he points out that a steady decline in the dollar is atypical, indicating that a reversal may be imminent.