Morgan Stanley: The time to sell dollars has come!

Morgan Stanley's latest report released on December 6 indicates that the timing for shorting the dollar has arrived.

The bank believes that the positive factors for the dollar have been fully priced in, while the market's generally bullish consensus on the dollar suggests that "painful trades" may be imminent.

The bank's analysis identifies three main reasons for shorting the dollar: first, although the U.S. economy is performing strongly, these positive factors have been fully priced in by the market; second, the market may have overreacted to the impacts of changes in trade policy; and finally, the market's expectations for Federal Reserve rate cuts may be overly conservative, while expectations for rate cuts by overseas central banks may be too high.

Additionally, several important events in December could have a substantial impact on the dollar's trajectory.

Three Reasons Supporting Shorting the Dollar

Morgan Stanley points out that the current market's generally bullish reasons for the dollar mainly include three: "U.S. economic data may continue to outperform expectations and be better than other global economies; changes in U.S. fiscal and trade policy may drive the dollar stronger; and the combination of these two factors will make it difficult for the Federal Reserve to maintain its rate-cutting pace."

However, the bank believes these factors deserve re-examination.

1. Positive Factors Have Been Fully Priced In

First, although the U.S. economy is indeed performing strongly—third-quarter GDP grew at an annualized rate of 2.8%, and personal consumption grew by 3.5%—these positive factors have been fully priced in by the market:

"Based on our conversations, the market consensus has clearly shifted to expecting the dollar index to rise in the foreseeable future.

However, when actual data deviates from expectations, those expectations often adjust. This is why the economic surprise index often tends to 'mean revert.'"

The bank further points out:

"In recent years, the economic surprise index tends to peak around +50, indicating that 'surprises' have reached their peak. From this perspective, the risk of data starting to come in below expectations is greater than the possibility of continuing to outperform expectations."

2. The Market May Have Overreacted to Changes in Trade Policy

Regarding trade policy risks, Morgan Stanley believes that the market may have overreacted to the impacts of policy changes, overestimating the speed, breadth, and magnitude of trade policy changes:

"While trade policy announcements may come quickly, their implementation may be slower and narrower than many investors expect... and will be executed through existing administrative authorities...

Tariff rates on Europe and Mexico will only rise slightly by about 1 percentage point... both in terms of magnitude and speed, far below the benchmark expectations of some dollar-bullish investors."

3. Divergence in Monetary Policy Expectations

Morgan Stanley emphasizes: "Our economists expect the Federal Reserve to cut rates by 25 basis points at each of the next four meetings, while the market only expects a total cut of 50 basis points by May next year. At the same time, the market's expectations for rate cuts by overseas central banks may be too high, especially for the European Central Bank." The bank wrote in the report:

"When we communicate with investors who are bullish on the dollar, they generally expect that strong economic data and uncertainty in fiscal and trade policy will prompt the Federal Reserve to slow down or even pause its rate-cutting cycle

Therefore, if the Federal Reserve's statements or dot plot suggest the opposite situation, it could pose significant downside risks for the dollar. Considering the importance of short-term interest rates in driving exchange rate movements, this is a potential outcome that forex investors should not overlook."

2. Seasonal and Technical Factors Unfavorable

Looking ahead to December, several important events could have a substantial impact on the dollar's performance.

Morgan Stanley specifically mentioned the seasonal factors in December:

"The seasonality in December is an important technical factor that is bearish for the dollar index, a characteristic that has been particularly evident over the past 10 years."

In addition, the bank believes that the dollar will face several important catalysts in December. "The European Central Bank meeting on December 12 could put pressure on the dollar index. The market currently expects a rate cut of 28 basis points (we expect 25 basis points), and if President Lagarde's comments are cautious regarding a 50 basis point cut, it could bring a mild hawkish surprise."

Most critically, the Federal Reserve FOMC meeting on December 18. Morgan Stanley pointed out:

"When we talk to dollar bulls in the market, they generally expect the meeting to emphasize that strong economic data and uncertainty in fiscal trade policy mean the committee should slow down or even pause the rate-cutting cycle.

Therefore, if the meeting sends the opposite signal, it could become a significant bearish factor for the dollar. Considering the important impact of front-end rates on exchange rate trends, this is a potential outcome that forex investors should not overlook."

Morgan Stanley emphasized that the market currently holds a generally bullish stance on the dollar, and such consensus expectations often indicate that the risk-reward ratio has changed. The bank advises investors to closely monitor the key time points mentioned above and consider adjusting their dollar exposure in a timely manner