As we enter the new year, the world is abuzz with uncertainty. From US policy on Venezuela and Greenland to the Supreme Court’s opinions and the pending announcement on who will replace Fed Chair Powell, there are plenty of factors at play. Meanwhile, the US labour market report has shown that there’s no need for the Fed to rush cutting rates again, and other activity indicators continue to point to a firm US economy. However, rising policy uncertainty has coincided with a weaker USD in the past, leading some to speculate about the dollar’s future trajectory. In this blog post, we explore two possible scenarios for the dollar: one where it remains on a pause, and another where positioning in the FX market becomes overextended.

Scenario 1: The Dollar Remains on Pause

The idea of the Fed being on a pause plays into the USD also being in a soft holding pattern. While some indicators suggest that net short USD positions are very overextended, we maintain that the DXY can soften modestly over the next few months due to the Fed’s easing bias and loose financial conditions. This means it pays to “buy quality,” preferring higher-quality EM FX and growth/hiking currencies such as the AUD, NZD, and SEK.

Scenario 2: Overextended Positioning in the FX Market

However, there’s also evidence to suggest that positioning in the FX market has become overextended. According to the CFTC data, net short USD positions are very overextended at the week ending January 6 this year, pointing to congestion in the FX market. Despite this, we maintain that the DXY can soften modestly over the next few months due to the Fed’s easing bias and loose financial conditions. This means it pays to “buy quality,” preferring higher-quality EM FX and growth/hiking currencies such as the AUD, NZD, and SEK.