Shorting the dollar: popular trade, painful price
Foreign exchange traders are eager to short the US dollar. The problem is the trade comes with a steep price tag.
Wall Street strategists are almost united in their view that the recent slump in the dollar will persist in the months ahead as a slowing US economy erodes the greenback’s long-held dominance. The problem for FX traders is that, while talk is cheap, shorting the greenback is decidedly expensive – a dynamic that is causing some to rethink their bearish bets.
That’s down to the negative carry that investors face when wagering the dollar will fall further against developed market currencies like the yen, Swiss franc and euro. The US’s far higher level of interest rates makes holding these positions costly, eating into any potential returns investors can make from the dollar’s weakening.
This effective tax on dollar shorts means investors need deep pockets – and a high pain threshold – to back their conviction of a sea-change for the world’s reserve currency even as it skids to its lowest level in more than three years.
“No matter how much someone wants to short the dollar – or hedge more of their dollar exposure – the cost of doing so is high, which is what’s preventing more widespread short positioning,” said Andreas Koenig, head of global FX at Amundi Asset Management.
“If you’re holding a short position and the dollar stays stable while you’re paying negative carry, there’s only so long you can hold that trade before you start reconsidering your position.”
The dollar hit a two-year high in January following the reelection of Donald Trump, but that euphoria swiftly evaporated as Washington’s erratic trade policy, rising debt levels, political fracturing and concerns over a slowing economy dragged the currency lower. Those headwinds have raised questions about whether US markets could lose the safe-haven status they have long enjoyed in the eyes of international investors.
ICE’s US dollar index, which measures the greenback against a basket of currencies, is down about 10% from its January peak. Morgan Stanley projects it could fall by more than 7% over the next 12 months as the US’s growth advantage over other developed economies fades.
"It’s not only tariffs that are weighing on the dollar, it’s also US foreign policy and fiscal policy – such as whether this 'big, beautiful bill' is actually sustainable," said Bimbola Fawehinmi, head of Americas FX trading at UBS. "Therefore, people have been looking to reduce their dollar holdings."
Higher rates
But while betting on a weaker dollar has already delivered bumper gains for some investors this year, putting these trades into practice is easier said than done. That’s because interest rate differentials only make it economically viable to short the greenback against a select group of currencies for sustained periods of time.
The Federal Reserve’s benchmark interest rate remains at about 4.3% as the central bank waits to see the effects of president Donald Trump’s tariff policies on growth and inflation. That contrasts with Japanese interest rates at 0.5% and the European Central Bank’s deposit facility rate of 2%. In Switzerland, short-dated bond yields have dipped below zero amid the spectre of deflation returning.
Giving up that extra yield investors can earn holding US bonds makes selling or borrowing dollars to buy these lower-yielding currencies punitively expensive. That means the dollar would have to depreciate sharply for bearish bets to pay off.
For instance, selling the greenback to purchase yen could cost 4% of an investor's yield on an annual basis, said Skylar Montgomery Koning, FX strategist at Barclays.
“The US has the highest policy rate [among G10 economies] … which means there is a cost with being short the dollar and hedging US assets,” she said.
Carry on
Ales Koutny, head of international rates at Vanguard Asset Management, said the short dollar story “may have legs” against sterling – where the rate differential is less pronounced – and certain high-yielding currencies, but it “generally starts looking much less attractive” when casting around for other options.
“Thematically, it makes a lot of sense to short the dollar right now but investing in some of the better performing currencies, like the Japanese yen or the Swiss franc, would see you facing a lot of negative carry," said Koutny. "That prevents shorting the dollar from becoming a ‘no-brainer’ position in the market."
That may explain why there are signs of some investors paring back their short dollar positions. Barclays’ dollar sentiment index, which uses inputs including data from the Commodity Futures Trading Commission and FX options markets, showed that bearish positioning on the greenback declined somewhat in early June after hitting a peak in the second week of May.
Fawehinmi said USB has started to see fast-money investors like hedge funds taking profits on their dollar shorts, helping to move overall short positioning back to levels seen in April. Some investors even say the dollar looks attractive in the near term because of the positive carry dynamics.
"We’re certainly taking a much more nuanced approach and while [we are] short [dollars] at the portfolio level, we have put on tactical long dollar trades against certain currencies [including the yen]," said Koutny.