Is the US dollar severely undervalued now? History seems to have provided the answer

The US dollar hovers near a one-year low, as Wall Street traders prepare for the upcoming Federal Reserve interest rate decision, sensing the latest signs of escalating uncertainty.

The US dollar index, which measures the dollar against a basket of six major currencies, has fallen by 3% since early August, currently only slightly above the low point in August, marking the lowest level in over a year.

The dollar is sensitive to interest rate expectations and forecasts for the US economic situation. Recently, traders have increased their expectations for a 50 basis point rate cut by the Federal Reserve, which is double the more traditional 25 basis point cut previously predicted by the market, putting greater pressure on the dollar.

Any such rate cut would lower US borrowing costs from the current range of 5.25% to 5.5%, the highest level in 23 years.

Mark McCormick, Global Head of FX and Emerging Markets Strategy at TD Securities, said, "Two things have driven the dollar lower: bets on Fed trades and the initial long dollar positions being squeezed out." He referred to traders reducing their bets on a stronger dollar.

Meanwhile, the appreciation of other major currencies has put downward pressure on the dollar, with the yen briefly rising above 140 this week for the first time since July last year. The yen's strength highlights the increasing divergence in expectations for US and Japanese monetary policies, with the Federal Reserve expected to lower borrowing costs while the Bank of Japan begins to raise its benchmark lending rate.

The recent decline in the dollar contrasts with a significant rise in US stocks, with the benchmark S&P 500 index hitting a new intraday high on Tuesday, underscoring diverging views among investors on the outlook for the world's largest economy across different asset classes.

This dynamic indicates that the dollar is only focused on the fate of the US economy, ignoring larger and more recent recessions in Europe and other regions, which could ultimately drive global funds towards the US as foreign investors prefer better-performing US stocks and traditional safe-haven assets such as the dollar and US treasuries.

McCormick stated, "The pricing of the dollar reflects the unique economic slowdown in the US. The dollar is ignoring what is happening elsewhere in the world. While the US stock market has performed poorly for two consecutive months, it does not mean that your funds have a better place to go."

Strategists also pointed out that unlike counterparts such as Japan, the US economy is not particularly reliant on exports, meaning that the recent weakness in the dollar has limited impact on US multinational companies.

Ajay Rajadhyaksha, Global Research Chairman at Barclays, said, "The US is too large and too closed of an economy to be affected by the fluctuations the dollar has experienced so far."

According to Karl Schamotta, Chief Market Strategist at Corpay, a global payment and foreign exchange risk management company, all of this indicates that the dollar is likely to rise soon.

He pointed out a historical trend in foreign exchange trading called the "dollar smile," which illustrates the special role of the dollar in financial markets: the dollar traditionally performs well when the US household economy is thriving and surpassing peers, and when the global economy is in a downturn, as investors seek the dollar for protection However, strategists say that the market's pricing of the US dollar may soon reverse.

Schamotta said, "We are currently at a smiling bottom. The global growth differential has narrowed. The US economy has started to lose momentum, but still relatively good. The market's bearish sentiment towards the US dollar is overly crowded."

Schamotta pointed out that data, including the unexpectedly rise in US retail sales in August released on Tuesday, indicates stable consumer spending. He also mentioned the GDP forecast of the Atlanta Fed, which currently shows that US GDP is expected to grow by 3% year-on-year in the third quarter. Schamotta stated:

"Data such as retail sales and the real-time forecasts of the Atlanta Fed tell us that despite the slowdown in economic growth, the US economy still has a solid foundation. The only weakness is the cooling of the labor market from its overheated levels during the pandemic."