The U.S. economy cools down amid tariff storms, and short sellers gather to bet against the dollar

According to the Zhitong Finance APP, last week, U.S. President Donald Trump's tariff threats once again boosted the dollar, but as signs emerged that the U.S. economy is cooling down and concerns grew that the trade war would further weaken the dollar, an increasing number of investors began to short the dollar. It is reported that asset management companies Invesco and Columbia Threadneedle, as well as hedge fund Mount Lucas Management, have joined the ranks of dollar bears. On Wall Street, Morgan Stanley and Société Générale warned clients that going long on the dollar is an overcrowded trade that may not last.

These investors are no longer focused on the daily fluctuations triggered by tariff announcements, but believe that the outlook for the dollar is only getting dimmer. The prospect of import tariffs reigniting inflation and maintaining high interest rates has not provided them with support, and now they are worried that all the uncertainty surrounding tariffs could undermine an economy that has already shown signs of cooling.

As a result, market expectations for a Federal Reserve rate cut have intensified, weakening the dollar's appeal. As investors begin to contemplate Trump's domestic and foreign policies, including cuts to federal spending, the exceptional atmosphere supporting the dollar's 7.1% rise last quarter is gradually fading.

"I don't think he can make the dollar appreciate too much because the dollar is really expensive," said Kit Juckes, head of foreign exchange strategy at Société Générale in London. "But can he make the dollar depreciate? He absolutely can, as long as he harms the U.S. economy."

Market Crisis and Geopolitical Impact

In the context of the dollar as the world's major reserve currency, a wave of risk appetite has pushed up stock markets and U.S. Treasury yields, with the dollar currently nearly 2% lower than its post-election peak before Trump's inauguration. Last week, people became aware of the dangers of shorting the dollar in the current environment. On Thursday, after Trump announced a 25% tariff on Mexico and Canada starting March 4, the dollar surged, recovering losses from February. He also stated that an additional 10% tariff would be imposed on Chinese imports.

Figure 1

On Friday, following a heated exchange between U.S. President Trump and Ukrainian President Zelensky, the dollar continued its upward trend. In an interview after the White House drama, Treasury Secretary Scott Basset reiterated that tariffs could bring in substantial revenue.

However, renewed attention to European defense may ultimately boost the region's currency against the dollar. On Monday morning in Asia, the euro strengthened as European leaders gathered to discuss increasing defense spending and ensuring Ukraine's security after reaching a ceasefire agreement mediated by the U.S.

The Polish zloty and Romanian leu also rose alongside other currencies in the Scandinavian Peninsula, as expectations of further spending are anticipated to promote growth in the region "Aside from the impact of geopolitical factors, this move also provides assurance to the market by reducing uncertainty and enhancing investor confidence," said Eli Mizrahi, managing partner at Targa 5 Advisors in Geneva. "Establishing a strong and lasting security framework for Ukraine helps support Europe's economic resilience and long-term stability."

Waning Enthusiasm and Economic Data

Domestically in the U.S., news regarding tariffs often benefits the dollar, as tariffs generally make imported goods more expensive, potentially harming demand for those goods and reducing the demand for purchasing those goods with domestic currency.

Meanwhile, last week investors realized the headwinds facing the U.S. economy, with the sale of existing homes dropping to a historic low and unemployment claims rising to their highest level this year, partly due to federal agencies announcing layoffs. It is this backdrop that has short sellers convinced they are moving in the right direction.

"For some time, the market has only priced in the positive aspects of government policy," said David Aspell, co-chief investment officer at Mount Lucas, which manages $1.7 billion in assets. "You also need to fully assess the measures they are trying to take that are detrimental to growth."

As enthusiasm for U.S. economic growth wanes post-election, the fund has shorted the dollar against other currencies such as the British pound and the Mexican peso. Meanwhile, due to better-than-expected European data, Invesco switched its position on the dollar from overweight to underweight a few weeks ago.

Figure 2

Ed Husseini of Columbia Threadneedle has been shorting the dollar against emerging market currencies since December. After the Federal Reserve hinted at slowing its easing policy, bullish positions on the dollar increased, and he thought he might not be able to gain more from this trade. The interest rate strategist stated that he plans to maintain his short position for at least six months.

The dollar's retreat from recent highs has reminded Morgan Stanley strategists of the situation at the beginning of Trump's first term in 2017. At that time, the dollar plummeted after he took office, reversing the gains it had made following his victory in the November 2016 election.

Bond Market and Fed Rate Cut Expectations

The shift in sentiment has also affected the U.S. Treasury market. As expectations for further easing of monetary policy by the Federal Reserve have intensified, traders have pushed the two-year Treasury yield down to its lowest level since October.

George Catrambone, head of fixed income at DWS Americas, stated that if more signs of economic weakness emerge, yields will decline, which is a "precursor to a drop in the dollar." "For the dollar to fall significantly, the market needs to expect further rate cuts, but ultimately it also depends on the actions of other central banks."

Currently, traders expect the Federal Reserve to cut rates by about 0.70 percentage points by the end of the year, while the European Central Bank is expected to cut rates by about 0.85 percentage points. This difference helps explain why the market overall still leans towards a stronger dollar For example, in the futures market, hedge funds and other speculators still tend to bet on a rising dollar, even after reducing their bullish bets to the lowest level since the end of October. But of course, the biggest unknown is how tariffs will play out.

Goldman Sachs strategists expect that if comprehensive tariffs are ultimately implemented, the dollar will rise further, stating in a report on Wednesday that the market is underestimating this risk. Meanwhile, Morgan Stanley indicated last week that the dollar's major currency pairs have become less sensitive to tariff announcements in recent weeks, which could prolong the dollar's decline.

As for investors, they do not seem to believe that the turmoil triggered by tariffs will end anytime soon. Alessio de Longis from Invesco stated, "Volatility may intensify, but I am not sure if the dollar will prevail."

Key Points to Watch This Week

Economic Data:

- March 3: S&P Global U.S. Manufacturing PMI; Construction Spending; ISM Manufacturing and Prices Paid; New Orders and Employment

- March 5: MBA Mortgage Applications; ADP Employment Change; S&P Global U.S. Services and Composite PMI; Factory and Durable Goods Orders; ISM Services Index; Federal Reserve Beige Book

- March 6: Trade Balance; Initial and Continuing Jobless Claims; Wholesale Inventories

- March 7: Non-Farm Payrolls Change; Unemployment Rate; Average Hourly Earnings

Federal Reserve Calendar:

- March 3: St. Louis Fed President Alberto Musalem

- March 4: New York Fed President John Williams

- March 6: Atlanta Fed President Raphael Bostic; Fed Governor Christopher Waller; Philadelphia Fed President Patrick Harker

- March 7: Fed Chair Jerome Powell discusses economic outlook; Williams; Fed Governor Michelle Bowman; Fed Governor Adriana Kugler

- March 8: Fed Quiet Period Begins