Federal Reserve Shift Drives Dollar Bear Market, Morgan Stanley Says

According to the latest analysis from Morgan Stanley, the U.S. dollar has entered a "bear market mechanism," driven by a shift in the Federal Reserve's policy stance. The Federal Reserve, following Chairman Powell's speech at Jackson Hole, has prioritized protecting the labor market over strictly controlling inflation. This policy shift is expected to provide sustained momentum for the dollar's bear market, as market pricing indicates that the dollar's interest rate advantage will decline by nearly 100 basis points over the next 12 months, significantly reducing the cost of shorting the dollar.

Morgan Stanley's strategy team highlighted that the Federal Reserve's reaction function has undergone a notable change, focusing on protecting the labor market even at the cost of higher-than-target inflation. This shift has led to significant revisions in the Federal Reserve's forecasts, with expectations of faster rate cuts to the terminal rate. Historically, during periods of a dollar bear market, other currencies have shown a high frequency of appreciation against the dollar, with substantial average gains. The consistency of this trend is particularly noteworthy.

The potential for a government shutdown in the U.S. adds another layer of risk for the dollar. The probability of a government shutdown has recently increased, which could further elevate the dollar's risk premium. A government shutdown typically results in economic slowdown, which has a negative impact on the dollar. Additionally, a shutdown would halt the release of government data, limiting the information available to the Federal Reserve ahead of its October 29 meeting. This data scarcity could influence market perceptions of the Federal Reserve's reaction function, potentially increasing the dollar's risk premium if the function is seen as decoupled from data.

Morgan Stanley has expanded its "dollar short list" to include the Australian and Canadian dollars, in addition to previously recommended positions such as long euro/dollar and short dollar/yen. The rationale behind this expansion is the anticipated reduction in the cost of shorting the dollar. Market participants have long cited the punitive interest rate differential as a challenge to holding short positions in the dollar. However, Morgan Stanley expects this differential to ease, with the cost of shorting the dollar decreasing by 50-75 basis points for most currencies, and by nearly 150 basis points for the dollar/yen pair. This reduction in the interest rate differential is expected to remove a key barrier to shorting the dollar, potentially accelerating the bear market dynamics.