Investors are being forced to rethink their bearish outlooks for the dollar, after mounting worries about a messy US election stoked a recovery in the currency.

Expectations of volatility have risen across financial markets as investors brace for a messy outcome in the race between President Donald Trump and his Democratic rival Joe Biden. This month, Mr Trump refused to commit to accepting a potential defeat in the poll, repeating his claims about fraudulent mail-in votes.

As a result, large banks and investors have started to reconsider their view of the dollar’s path for the rest of the year. The currency fell 10 per cent from its coronavirus peak to its low in August. But months of an unknown outcome in the race for the White House could unsettle markets and send investors scrambling for the safety of the greenback, analysts say.

“The US election has the potential to be a significant market mover,” said Francesca Fornasari, head of currency solutions at Insight Investment. Mr Trump’s shock win in 2016 demonstrates that running lower levels of risk is “probably wise”, she added.

Shahab Jalinoos, head of currency strategy at Credit Suisse, cited US election risk as a key factor in his team’s decision to predict a stronger dollar, over a four-week horizon, after months of calling the currency lower.

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“For the first time since May, we have decided to shift lower our one-month target for the euro against the dollar,” Mr Jalinoos said. He sees the euro pulling back to $1.16, having previously said in August that he expected a rally towards $1.21, in part because of the EU’s plan to pool debt in an effort to finance a recovery from coronavirus. “The question now becomes whether to hold on to our $1.21 [trade] target at all,” he added.

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And Ben Randol, a currency strategist at Bank of America, pointed to “substantial economic and event risks ahead”, adding: “We expect a dollar rally into the election and possibly beyond.” The bank now forecasts the euro to lose ground against the buck to trade at $1.14 by the end of the year, from the current level of above $1.16.

A sustained rally is not yet at hand. A stumble on Monday sent the dollar index down about 0.3 per cent by late morning in New York.

But if it does stick, it would mark a sharp reversal in the dollar’s fortunes. Investors had turned negative on the currency in large part because of the Federal Reserve’s aggressive response to the pandemic since March; the central bank’s sharp cuts to interest rates reduced the reward for holding dollar assets. Some had expected the euro to reach as high as $1.23 by year-end.

But since the start of September the greenback has gained 2.4 per cent against a basket of its peers after four months of declines, while the euro’s spectacular rush higher has started to sputter.

Line chart of US Dollar index showing Dollar on the rise for first time since March

For dollar bulls, this is the start of a fightback.

HSBC, one of the world’s largest currency-dealing banks, began 2020 with a loud call for the dollar to climb — a view that unravelled quickly in July, the dollar’s worst month in 10 years.

But Dominic Bunning, a senior currency strategist at HSBC, warned it would be a mistake to underestimate the dollar’s role as one of the world’s preferred shelters in times of stress — even if that stress does originate in Washington.

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“When we get those periods of uncertainty from the US, the initial thought is that is something negative for the dollar,” Mr Bunning said. “The problem with that view is that even when problems emanate from the US . . . the dollar [still] does well as a safe haven asset.”

Line chart of EUR/USD showing Euro gains stall in September

Some dollar bears are undeterred.

Futures markets suggest that the bulk of investors are still not betting on the dollar shooting higher on the back of safety-seeking bets. Backing the euro to strengthen against the greenback remains the most popular trade, although with a smaller margin than at its peak earlier in the year.

The political fallout could turn out be bad for the dollar, reflecting that risks from the elections are specific to the US, said Jean-Baptiste Berthon, a strategist at Lyxor Asset Management.

“Political uncertainty — and in turn rate volatility — could persist for longer than observed following recent elections,” he added.

But Stephen Jen, who runs hedge fund Eurizon SLJ Capital, said that the consensus that had built up among investors expecting the dollar to keep falling had become excessive, particularly given the chance that the US economy could recover faster than the rest of the world. “I’ve been doing this for 25 years and it’s the first time in my career I am seeing such an overwhelming consensus view to one way . . . virtually everyone believes the dollar will collapse.”

Line chart showing how Trump and Biden are doing in the US national polls

Via Financial Times