Dollar bears might have miscalculated

The dollar has long been a safety trade for global investors. But in post-recessionary phases with the help of fiscal aid, it can double as a bet on a global recovery.

With that in mind, as capital flows to the US increase, so might bids for the currency — to the dismay of traders who entered 2021 with overstretched short dollar positions.

The US has pumped trillions of dollars into the economy, with more to come, all of it aimed at supporting the economy through the pandemic and jumpstarting it as vaccinations take hold. The market is pricing it in, as investors increasingly favour economically sensitive assets such as small-cap stocks.

“The consensus on economic forecasts already shows the US as one of only two major economies expected to end this year larger than it started last year,” said Elsa Lignos, global head of forex strategy at RBC Capital Markets.

As American jobs and spending bounce back, international investors are likely to rush to gain exposure to the US recovery, possibly sparking a rotation out of foreign equities and into US stocks. To do that, they’ll need dollars. And those capital flows are likely to boost the greenback.

The consequences of a dollar rebound could be far-reaching. In stocks, the inverse correlation between the greenback and S&P has been at multi-year highs since the pandemic began.

Dollar weakness gives global investors an incentive to buy US equities, which are seen as expensive. With a rush to US stocks, and consequently the dollar, that relationship could break down as both rise. Even commodities could become less sensitive to the greenback.

Shorting the dollar has become an extremely crowded trade after the currency pared not only its 2020 gains but also the safe-haven bids it saw throughout the trade war with China. The Bloomberg Dollar index is now at its lowest level since April 2018, right before the conflict intensified.

Technicals show the greenback may be looking at a reversal after a nine-month slide since the March crash. Despite the downtrend from its 2020 peak, there is support at the 2018 low.

It’s unlikely, however, to be a straight shot up. Given the influx of stimulus in the near term, the dollar could weaken first. As the economy recovers, investors are likely to abandon the dollar and metals as havens and buy risk, like emerging-market assets. But that may not last long.