Is Time up for the Dollar’s Rally? Don’t Count on It.

Last week, the dollar notched up its worst week since the early days of the Covid-19 pandemic, but analysts think a long-running stampede for the greenback might not be over just yet.

The Bloomberg Dollar Spot Index slumped around 3.5 percent, its biggest loss since March 2020. Investors had been trimming bets on the dollar ahead of Thursday’s U.S. inflation data, with a slowdown in prices leading it to get pummeled in the index’s worst one-day performance since 2009 as traders dialed back bets on how much policy tightening they expect the Federal Reserve to implement.

The latest selling means the dollar gauge is now 6 percent below the record peak it hit in late September, with the yen the main beneficiary. While the moves suggest the greenback could stay under pressure in coming weeks, on bets the Fed will start lifting interest rates in smaller increments, market participants remain cautious that the trend will continue in the longer run.

“The dollar peak might be past us, but a dollar downtrend may not be there yet,” ING Groep NV analysts wrote in a note, adding that the Dutch bank remains “moderately bullish” on the dollar into year-end.

The Bloomberg Dollar Spot Index climbed by more than 22 percent from its mid-2021 low to its September 2022 peak, and even with recent declines, it’s still up more than 14 percent from last year’s nadir. That strength has rippled across markets, exacerbating the cost of dollar-denominated goods such as oil and complicating policy around the world. U.S. stocks and bonds rallied this week as the dollar slid.

Strategists at MUFG said that a weaker dollar was now “justified,” while adding that the scale of the move clearly reflects to some degree the “pain trade” seen earlier in the week when investors cut back on overly big bets on the dollar. Instead, funds have been piling into the yen, up more than 5 percent this week after hitting a three-decade low less than a month ago.

Currency strategist Lee Hardman likened the market’s positioning and the selloff in the dollar to an elastic band stretched in one direction, “and when you let go, you get a bigger reaction the other way.”

Given the massive scale of dollar bets that have accumulated this year, he sees the possibility of a further 2 percent to 3 percent move lower in the U.S. currency before the end of the year. That could take it down toward 130 against the yen, from around 139 at the moment, while against the euro it could weaken to about 1.05, from present levels around 1.036.

But with a global recession looming, the war in Ukraine continuing, and growing signs of a slowdown in China, it could be too soon to aggressively sell the dollar, which is often viewed as a haven in times of trouble.

“It was inevitable that once the turn came, there was going to be a sharp move to the downside, which is what’s playing out,” Hardman said. “Now, the risk is that the move will be overdone, as we’re still far from an end to the Fed tightening cycle at this point.”

Traders will be on the lookout for any further signs of a cooling U.S. economy that could enable the Fed to dial back its tightening following a series of jumbo hikes. Four officials have backed a downshift, even as they stressed that monetary policy needs to stay tight.

A deeper dollar selloff would require more confidence that inflation is falling back quickly and speculation that the Fed may need to start cutting rates due to recession risks, Hardman said. But such a situation could, in turn, spark fresh haven demand for the greenback, he added.

For technical-chart watchers, the dollar could extend its recent losses all the way down to August lows, according to several momentum indicators. A key support level, the 32.8 percent Fibonacci retracement of the May 2021 to September 2022 rally, is 1.3 percent lower than current spot levels.

That could be as far as the retreat goes, if options are any guide. Risk reversals, a barometer of market positioning and sentiment, have retreated to the least bullish sentiment for the greenback since May, yet show that investors aren’t convinced of a huge selloff.

“Risks are that the positioning squeeze could continue,” said Alex Jekov, a G-10 currency strategist at BNP Paribas SA. “But it’s tough to argue that this necessarily will elicit a huge turn in the dollar in the medium term, given that the CPI data is one print and we haven’t changed our terminal rate forecast, which ultimately is key for the dollar.”

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