Euro and Pound Surge as Dollar Stumbles Amid Fed Rate Cut Speculation

The recent surge in the euro and the British pound to their highest levels this year against the US dollar has captured significant market attention. This development coincides with a notable decline in the US dollar, attributed to various factors influencing investor sentiment and market dynamics.
Robust consumer spending and growing optimism about multiple rate cuts by the Federal Reserve this year have favored risk sentiment but have worked against the dollar. Predictions of Fed rate cuts have intensified, resulting in the dollar's downward trend, reaching new lows for the year.
As concerns over an economic recession ease, risk appetite has revived, leading to a decline in the dollar. The dollar index has fallen 2.2% this month, hitting its lowest level since the first trading day of January. Amid this weakening, the S&P 500 has recovered nearly all losses incurred since the start of August, indicating improved market sentiment.
The market is anticipating a soft landing and imminent Fed rate cuts, contributing to the dollar's slide. Strong retail sales data has renewed confidence in the economy, with expectations for the Fed to cut rates three to four times before year-end. Following a weak employment report, traders have increased their estimates for rate cuts to five times this year. The CME FedWatch Tool indicates a 32.5% chance of a 50 bps cut in September, up from 24% earlier this week, and a 67.5% probability of a 25 bps cut.
In the first half of this year, the dollar index had risen due to unforeseen resilience in the US economy. However, since late June, as the economic expansion slowed, the dollar index began its downward trajectory. Recently, this weakening trend has accelerated as investors shift from the dollar to other risk assets.
Jane Foley, head of FX at Rabobank, remarked that the US is likely heading into a mild recession, aligning more closely with other economies. She noted that the euro, the dollar's main competitor, has been particularly strong this year. Despite weak German manufacturing, the euro has appreciated 3.6% against the dollar since early July.
The decline in the dollar is partly driven by investors abandoning the popular carry trade, where they borrowed yen to buy higher-yielding dollars. This strategy has led to the yen appreciating over 7% against the dollar in the past month. Data from the US Commodity Futures Trading Commission shows that short bets on the yen reached their highest levels since 2007 but have sharply declined in recent weeks, with long positions emerging for the first time since 2001.
Chris Turner, head of research at ING, commented that dollar positions are now flat and far from expanding, posing the question for the rest of the year: do investors want to short the dollar? According to Michael Metcalfe, head of global macro strategy at State Street, the dollar outlook hasn't fully shifted yet. This change might only occur when the pace and depth of the Federal Reserve's easing cycle become clearer.