US dollar on thin ice as traders rush for the exits

A fallout from the rapid swing in expectations for U.S. interest rates could cause the dollar to cave in next month as traders who are on the wrong side of the trade for this major pivot will be forced to exit.

There is a chance of rapid unwinding of positions stemming from the unexpected changes in the interest rate outlook that have coincided with the traditional year-end drop in liquidity.

Today the dollar index touched a new 5-week low, while gold hit a 7-month high as markets bet big on the Federal Reserve cutting rates as early as March 2024. Interest rates, which were seen rising further following September’s Federal Reserve meeting, are now expected to fall as much as 110 basis points next year, and chances are increasing that the first cut could come in the first quarter of next year.

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Currency traders, who have been mainly betting on the dollar rising, have been caught out by the pace of change, and that pace is accelerating a little too fast too soon. A surge in bond yields, which prompted many to sell short, will add fuel to the fire, with demand from investors keen to buy an asset with an attractive yield squeezing speculators who have sold.

The yield on U.S. 10-year debt dropped 0.75% in November, driving interest rate differentials that influence currencies far against traders invested in the dollar.

USD/JPY, the most favoured dollar carry trade, is a good example of this disparity. USD/JPY was 140 when the one-year forward swap was at a similar level to that trading today, yet USD/JPY is above 147 with traders long. Those long may find their exit window narrows quickly, resulting in a sharp drop.