Dollar is highly oversold. A Reason for Concern?

What's Behind the Dollar's Weakness?

• Trade Policy: Currently, uncertainty regarding Donald Trump's trade policy is most frequently cited as potentially leading to a recession in the United States. Although tariffs were initially considered positive for the US dollar, they may work against it in the longer term.

• Weaker Economic Data: Recently, data from the US economy has been performing below expectations, though this doesn't mean the data is weak. The market indicates that Friday's NFP data showed considerable weakness. Generally, it came in at a solid level of around 150,000, which doesn't show the kind of labor market cooling that would prompt the Fed to react. Nevertheless, the economic surprise index for the US is negative and beginning to resemble the trajectory of Trump's first presidency. Meanwhile, the surprise index for the eurozone is clearly positive.

Economic surprise index for the US, eurozone, and China. As can be seen, the current situation looks worst from the US perspective. Source: Bloomberg Finance LP, XTB

The GDPNow model from the Atlanta Fed currently indicates a strong recession in the first quarter of this year, which is associated with the powerful impact of the trade deficit driven by uncertainty regarding trade tariffs. Source: Atlanta Fed

• Rising Expectations for Fed Rate Cuts: Until recently, market expectations indicated a terminal rate of 4%, which meant just under two rate cuts based on the effective rate (the main rate ceiling in the US is 4.5%, while the effective rate is 4.33%). Currently, the effective rate at year-end is priced at 3.5%, which means pricing in at least 3 cuts.

The effective rate at year-end is priced at 3.5%. Source: Bloomberg Finance LP, XTB

• Growing Demand for Foreign Currencies and Higher Real Rates: While yields in the US have declined after a strong increase at the beginning of the year, in Europe we observed a strong rebound, which is associated with the expectation of large debt issuance for huge military and infrastructure spending. Yields in Germany rose to their highest levels since 2023. Despite the decline in yields at the beginning of the new week, the decline in the US was greater, leading to a further increase in the spread.

When the spread was last at such a high level, EURUSD was trading at 1.10-1.12. Source: Bloomberg Finance LP, XTB

The speculative demand for the euro itself is growing. Although net positions are still negative, we observe a simultaneous reduction in short positions and an increase in the number of long positions. If this trend continues, it may be possible to repeat the situation from 2022. Source: Bloomberg Finance LP, XTB

• Disappointing Donald Trump? The behavior of the dollar since the US elections has been very similar to the situation in 2016. The dollar first gained in value, but shortly after Trump's first decisions, it began to lose. The dynamics of the dollar's sell-off are currently stronger than after the 2016 elections, but it's worth remembering that at that time, the sell-off extended throughout the entire 2017 year.

The dollar's performance resembles the years 2016-2017. Will the dollar follow a similar path? After the 2016 elections, the dollar lost 4.5% in value over the perspective of 200 sessions. Source: Bloomberg Finance LP, XTB

Further weakness of the dollar may have significant consequences for the US economy and the entire world. Theoretically, it may increase the competitiveness of American exports, but at the same time, with the current aversion associated with the trade war, additional buyers for American products may not necessarily be found. On the other hand, a weaker dollar may mean slightly higher import inflation, although this should not be a significant problem. A weak US dollar may mean a decrease in the value of many countries' foreign exchange reserves, which may lead to a further desire for diversification, particularly toward gold, which has significantly gained in value in recent months. It's worth mentioning that over the last 3 years, central banks have purchased over 1,000 tons of gold annually, and this situation is likely to repeat itself in 2025.