Weak Dollar – is this a new reflation trade?

While one could expect a weak dollar just before the Fed’s pivot (I wrote about it in May this year, giving three reasons why the dollar will weaken: link) – the current scale of the weakening is a bit surprising…

Figure 1 shows the DXY (dollar index) and its components since January 1, 2022. In March 2022, we had the start of hikes in the US, in September 2024 we will have the start of cuts. During this period, only the Swiss franc strengthened against the dollar.

A weak dollar (and a strong euro) can generally be interpreted in two ways:

1) The market is currently strongly betting on a soft landing scenario, or even the beginning of a new “reflation trade”. Previous reflation trades are clearly visible in the strong increases in EURUSD – see Figure 2 – blue circles. But in 2017 and 2020, reflation trades started from practically zero policy rates,

2) We only have strong currency movements due to the full confirmation of the pivot by Powell in Jackson Hole plus further strengthening of these movements by the risk of more leverage/carry trades unwind - especially since the currencies financing the carry trades are strengthening. The movement in currencies may be additionally strengthened by Trump's upward shift in the polls (remember how strong the reflation trade was after Trump's victory in 2016).

All in all, I am definitely closer to the second scenario, because a new "reflation trade" starting at 5.5% level of US policy rate seems a bit doubtful ...