US dollar drops to three-week low as traders weigh a Fed pivot

A gauge of the dollar dropped to a three-week low as traders bet the Federal Reserve will temper the pace of its rate hikes amid signs the world’s biggest economy is starting to slow.

The Bloomberg Dollar Spot Index fell as much as 0.9%, sliding along with benchmark Treasury yields for a second day. Traders are pricing the upper bound of the Fed’s target range will peak at about 5% in 2023 compared with almost 5.20% last week.

The repricing is benefiting the euro and the pound, with the common currency advancing past parity with the US dollar for the first time since September 20. Sterling jumped as much 1.3% to $1.1620, the highest level in more than a month.

A slew of US data on manufacturing, home prices and consumer confidence have all fallen short of economist estimates, underscoring the toll of Fed tightening. Meanwhile, Federal Reserve officials have sounded a more cautious note, with San Francisco Fed President Mary Daly saying last week that policy makers should start planning for a reduction in the size of interest-rate increases.

“We are probably on the last leg of USD strength,” said Themistoklis Fiotakis, head of FX research at Barclays Bank in an interview on Bloomberg Television on Wednesday. “It’s pretty clear that a lot of the components of the US economy are starting show signs of peaking, be it wage growth, inflation growth or whether that is the housing market.”

The 10-year Treasury yield fell as much as 8 basis points to 4.02%, down from this month’s high of 4.34%. The euro was 0.8% stronger at $1.0047 as of 10:32 a.m. in London.

Dollar squeeze?

With many investors still positioned for more dollar gains, the market is at risk of a squeeze. Bullish greenback bets are around double the average over the last five years, according to Bloomberg CFTC non-commercial futures.

The dollar’s slide is also being compounded as bearish sentiment toward the pound and the euro shift. UK assets rallied after former Chancellor of the Exchequer Rishi Sunak was appointed prime minister, signaling an end to a planned expansive fiscal policy under Liz Truss that had plunged markets into turmoil.

The euro also is strengthening following a decline in natural gas prices which should improve the eurozone’s terms of trade position, according to ING Groep NV strategist Chris Turner. A break of parity “could trigger quite a sharp short squeeze to $1.02,” he added.

The brighter outlook for the common currency is manifesting in the options market, with one-week risk reversals for the euro-dollar pair trading at their least bearish levels since February. Hedge funds have cut their euro-short exposure to the lowest since June, according to CFTC data.

Still, how far this trend continues will be in part determined by the European Central Bank’s meeting on Thursday and Fed’s rate decision next week. Ahead of that, traders will also be watching out for upcoming US data including new home sales later Wednesday.

“Markets haven’t got much conviction and fuel to chase hawkish Fed trades right now especially when you’re seeing warning shots around ‘over-tightening’ fears in housing data,” said Viraj Patel, a senior strategist at Vanda Research in London. “So we’re starting to see 10-year yields drift lower.”

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