All signs point to a tough time predicting the dollar’s ​​path in the coming months after the U.S. presidential debate and a key inflation data set led markets to expect heightened volatility toward the end of the year.

Currency fund managers are grappling with a dizzying array of information that will further fuel market volatility. With the Federal Reserve preparing to cut interest rates next week and the U.S. election looming, a measure of three-month implied dollar volatility reached its highest level since the regional banking crisis in early 2023.

Bloomberg Dollar Volatility Index rises

Fund managers say the key is determining the trajectory of the Federal Reserve, which they expect will be the main driver of the dollar. But beyond that, they must figure out whether markets are pricing in room for the Fed to ease relative to major central banks and how to position bets around the U.S. election in November. At the same time, they must navigate a host of escalating geopolitical tensions that could affect markets in unpredictable ways.

“Predicting short-term currency moves is extremely difficult,” said Derek Schug, head of portfolio management at Austin-based Kestra Investment Management. “We are setting ourselves up for an extremely volatile path for the dollar for the rest of the year.”

The dollar edged lower after Tuesday's U.S. presidential debate as traders further unwound bets tied to former President Donald Trump defeating Vice President Harris in November. The dollar has yet to recover much ground from its August plunge, more than halving its gains for the year. Speculators remain the most bearish on the dollar in more than a year even after August's better-than-expected U.S. core CPI as markets expect the Federal Reserve to cut interest rates by around 100 basis points by the end of the year.

Here's what some fund managers think about the dollar's trajectory and the trades they recommend.

Kathleen Brooks

Brooks is director of research at XTB, which was the most accurate forecaster of major currencies in the second quarter, according to data compiled by Bloomberg.

“Without a doubt, the No. 1 driver of the dollar’s ​​performance is going to be relative interest rate differentials,” she said. “The outlook for the dollar for the rest of the year is probably really going to be determined by the next few weeks.”

Brooks said any reduction in bets on Fed rate cuts could give the dollar some breathing room. “I don’t think the election is a critical factor in foreign exchange markets,” she added. “We are on the precipice of a change in monetary policy, and that’s much more important to the market right now than politics.”

As for trading, Brooks said, “Forex has been less volatile than any other asset class this year, but you’re probably going to see a gradual recovery of 2.5% in the dollar. So who’s going to pay the price? The yen and the euro.”

Still, she expects the euro to trade in a range of 1.11 to 1.08 against the dollar over the next three to six months.

Kristina Campman

Campmany is a senior portfolio manager on Invesco’s global debt team, managing $6 billion in assets.

She believes: "With the Federal Reserve about to start an easing cycle and move interest rates closer to neutral levels, the dollar may be in a more persistent downturn in the future."

Such a correction could cause the dollar to fall by as much as 5%, or as much as 10% if the Fed's easing policy remains at a neutral level, Campmany said.

In terms of trading strategies, she said, “it has been possible to execute the carry trade in a relatively efficient manner over the past year,” where investors borrow where interest rates are lower and invest where they are higher. We believe this will continue as long as global economic activity remains strong.”

Invesco favors high-yielding currencies such as the Mexican peso and Brazilian real, noting the particular pressures they have faced recently. They prefer to fund these positions in U.S. dollars, as well as the euro, yuan and Swiss franc.

Meera Chandan

Chandan is co-head of global foreign exchange strategy at JPMorgan Chase & Co. The firm was the second-most accurate forecaster of major currencies in the second quarter, according to data compiled by Bloomberg.

In her view, “the dollar at this juncture is splitting the currency market into two parts, low-yielding and high-yielding currencies. The currencies that were hardest hit when U.S. rates were rising, the low-yielding currencies, are probably the ones that are most supported now as rates come back down.”

Chandan said the dollar's performance will ultimately depend on the U.S. growth outlook. "That doesn't even factor in the impact of the U.S. election."

In terms of trading strategy, she said, “We are defensively bullish on the dollar. We are still looking for dollar strength, but it is different from the dollar strength we have seen in the past few years. Support for the dollar is likely to come from risk-off trades rather than outperformance in U.S. economic growth and high yields.”

In a recession, the dollar could fall to below 135 yen from 142 now, or even below 130, she said. However, "the dollar could still strengthen because all cyclical currencies weaken."

Jonathan Duensing

Duensing is Amundi's head of U.S. fixed income, leading a team that manages about $50 billion in assets.

“Given the extent of the discount at the front end of the Treasury yield curve, it is understandable that the dollar has weakened to the point it has,” he said. “But in our view, it looks a bit oversold in the short term.”

If the risk of a U.S. recession increases, the dollar could rebound as investors flock to quality assets, Duensing said. But if the Federal Reserve eases policy more than the market is currently pricing in, the dollar could weaken.

In terms of trading strategy, he said, “If the Fed achieves a soft landing on inflation and they are able to keep the U.S. economy growing at potential, you could see a 3% to 5% upside to a 5% downside in the dollar over the next year or so.”

Leah Traub

Traub is a portfolio manager and head of the foreign exchange team at Lord Abbett, responsible for managing approximately $12.7 billion in assets.

“When I think about what’s going to move the dollar through the end of the year, the most important things to me are the Fed starting to cut rates, then the outlook for global growth, and then the election,” she said.

Traub said that as the Federal Reserve cuts rates, the U.S. interest rate advantage could narrow. If the Fed cuts rates by 25 basis points in September, it may take a similar step in November, which could weigh on the dollar. However, this scenario is also priced in.

“For the dollar to remain depressed, we need to see faster global growth, even if U.S. growth slows. I look around the world and I don’t see that happening for a while,” she said.

In terms of trading strategy, the firm does not make big bets on currencies, but instead reflects views on U.S. and non-U.S. assets through bond allocations.

“As the U.S. economy shows signs of slowing and the Fed becomes more dovish, we have shifted more duration exposure back to the U.S. while maintaining excess exposure to non-U.S. credit,” Traub said.

Hedging costs for dollar-denominated assets remain favorable, she said. For example, buying a euro-denominated bond and swapping it for dollars through a three-month forward contract would add 1.6% to the annualized spread, she said.

Article forwarded from: Jinshi Data