In our previous take on the US dollar in early February, we wrote that the currency was set to remain weak. At the time, ex-US growth was accelerating, while speculator sentiment was only mildly bearish. While dollar bulls have argued that rate hikes should help the currency, we wrote that expectations for monetary tightening were rising around the world, limiting the impact from the Fed’s actions. Since that time, the dollar has traded sideways in a narrow range. Looking at the US dollar index (a weighted measure of the currency against its largest peers), the dollar was trading around 90 and remains at similar levels today.

As dollar trades sideways, outlook looking increasingly neutral

Since our previous commentary, ex-US growth has decelerated significantly, particularly in the Eurozone. Turning to sentiment, speculator net short positions in the US dollar are now 50% larger relative to last February. As growth slows while speculators chase momentum in the euro, the ongoing rally in assets negatively correlated with the US dollar is looking riskier. This is particularly true for the euro, which we covered in greater detail in a recent commentary. An additional concern is the Hong Kong dollar, which may develop into a significant risk in a larger downturn.

While the buck has been selling off for the last 15 months, we argue that investors should prepare for a stronger dollar. Over the coming weeks, we expect to upgrade our medium-term outlook on the dollar to neutral (from bearish today) as a result.

As ex-US growth deteriorates, USD liquidity pump running dry

As the world’s reserve currency, the US dollar trades inversely to global growth expectations. This is because the dollar is the most popular liability currency, meaning it is borrowed heavily for cross-border investments. When optimism for global growth is running high, investors tap US capital markets in order to finance international investments. While borrowing dollars is relatively more expensive than currencies with negative interest rates (such as the euro), the buck remains the most popular option given the significant scale and liquidity offered via US capital markets. During boom times, more and more dollars chase foreign investments, weakening the currency. When the inevitable downturn strikes, borrowers struggle to repay USD loans, and sell assets in order to raise cash.