It’s a tough day for the U.S. dollar, but here’s why things might still look up

The Federal Reserve’s failure to more forcefully set the stage for the eventual tapering of its monthly bond purchases continued to get the blame for a weaker U.S. dollar for a second straight session Thursday, with the benchmark index falling to its lowest level of July.

But analysts said the weakness may be overdone.

The ICE U.S. Dollar Index
a measure of the currency against a basket of six major rivals, fell 0.5% to 91.88, trading at its lowest since June 29. The index is down 1.1% this week, trimming its year-to-date gain to 2.2%.

The dollar “seems to be taking its cue from timing of the taper announcement, and a touch of disappointment on that front,” said Elsa Lignos, global head of FX strategy at RBC Capital Markets.

Ahead of the Fed statement on Wednesday, there had been speculation the central bank would set the table for an announcement on tapering its bond purchases at its September meeting, Lignos said. But that appeared unlikely after the Fed statement said progress would be assessed in “coming meetings” and as Chairman Jerome Powell’s remarks in his news conference seemed to indicate odds were very low, she said.

Read: Fed says economy has ‘made progress’ toward standards for tapering, but not enough to start yet

Market expectations for Powell to announce a taper plan at a Fed symposium in Jackson Hole, Wyoming, next month were also being questioned, she noted, arguing that the reaction may be overdone.

Also see: Strong, but disappointing, U.S. GDP report may be bad news for the Fed

“But the timing of the first hike has crept a bit closer, if anything,” she said. “Ultimately that should be where USD (U.S. dollar) takes its cue, so we see the post-FOMC price action as a reversal of USD strength of the last couple of days, rather than anything more meaningful.”

Recent dollar softness has given back only a portion of the sharp gains scored after the Fed’s June 16 meeting, which was seen putting policy makers on the path to reining in monetary policy more quickly than had been anticipated.

The June meeting may prove to be an inflection point when it comes to sentiment around the dollar.

Economists at the Institute for International Finance, in a Thursday note, observed that the rally that followed the June meeting erased a substantial dollar short position that had previously built up in the foreign exchange market amid deep-seated worries about the long-term role of the world’s reserve currency in the global financial system.

“One year ago, markets were buzzing about dollar reserve currency status. Sentiment was very negative, given large U.S. budget deficits that were being heavily financed by Fed [quantitative-easing] purchases of Treasury securities,” wrote Robin Brooks, Jonathan Fortun and Jack Pingle.

Based on positioning data on currency futures from the Commodity Futures Trading Commission, dollar positioning by speculative traders is now flat, a big change from just before the June Fed meeting, and likely setting the stage to a shift to a long position in the dollar, they wrote (see chart below).

Institute of International Finance

“This would be consistent with the U.S. outspending everyone else on fiscal stimulus, which conceptually should move rate differentials in support
of the dollar,” they said. Rate differentials are the difference between yields in two different countries; higher yields generally attract capital and boost the value of a currency.

See: Bipartisan infrastructure deal still faces long, uncertain road

The economists said “radical sentiment shifts” of the type seen following the June 16 meeting “are rare and usually signal a broader turn. It is therefore our expectation that positioning is about to turn long USD, after being dollar-negative for much of the past year.”

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