Dollar Trapped in Negative Feedback Loop as Foreigners May Flee

(Bloomberg) -- The dollar has peaked and its weakness may become a negative spiral as foreign investors exit due to the poor currency-hedged returns of U.S. assets, according to Morgan Stanley.

Markets are underestimating the potential for the dollar to fall based on shifts in U.S. growth and the Federal Reserve policy narrative, the bank said. It forecasts the yen climbing to 102 per dollar and the euro to $1.31 by the end of the year, while Nomura International Plc expects foreign selling to weigh against the greenback.

Dollar Trapped in Negative Feedback Loop as Foreigners May Flee

“Dollar weakness could feed on itself if foreign investors are forced to consider the poor FX-hedged returns of U.S. assets,” Morgan Stanley strategists including Andrew Sheets wrote in a note. “For investors outside the U.S., this cost of hedging U.S. assets back into local currency has almost never been higher.”

Decelerating U.S. growth and the Fed removing its reference to further gradual interest rate increases last week are underpinning Morgan Stanley’s base case for the dollar weakening beyond consensus forecasts. It sees the potential for even larger downside moves linked to how investors handle hedging.

An investor from the euro-area would get a return of minus 0.35 percent on benchmark 10-year Treasuries, compared to its actual yield of 2.70 percent, according to Bloomberg calculations. Hedging costs haven’t mattered in recent years due to the sustained period of dollar strength, but expectations for a weaker dollar have changed that, Morgan Stanley said.

Foreign investors were seen selling U.S. equities while domestic funds were selling overseas bonds according to the latest U.S. capital flow data for November, according to Nomura.

“For the dollar it seems there is a battle between U.S. investors bringing money home through selling foreign bonds and foreigners selling U.S. equities,” said Bilal Hafeez, Nomura’s head of Group-of-10 currency strategy, in a note. “Given foreigners invest more in the U.S. than the U.S. invests abroad, I think the balance will tip against the U.S. dollar.”

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