The dollar may face sustained and broad-based selling pressure, according to the latest assessment from Morgan Stanley, which also views a government shutdown as a "potential negative" factor for the dollar.
On September 23rd, Morgan Stanley stated in its latest research report that the dollar has entered a "bear market mechanism," expecting this condition to persist for an extended period, bringing widespread dollar selling pressure.
Morgan Stanley strategist David S. Adams believes that the Federal Reserve has clearly shifted to prioritizing employment market protection following Powell's Jackson Hole speech, even at the cost of tolerating above-target inflation. This policy stance shift provides sustained momentum for the dollar bear market.
Morgan Stanley points out that crucially, market pricing shows the dollar's interest rate differential advantage will decline by nearly 100 basis points over the next 12 months, which will significantly reduce the cost of shorting the dollar.
With U.S. government shutdown risks rising, Morgan Stanley considers this a potential negative for the dollar. Polymarket data shows government shutdown probability has risen noticeably recently, which could further increase the dollar's risk premium.
Fed Policy Shift Triggers Dollar Bear Market Mechanism
Morgan Stanley had predicted in its mid-year outlook that the dollar would continue weakening, but at that time expected the most likely market mechanism to be a "defensive mechanism," where real rates and breakeven points decline simultaneously.
However, the actual situation since May has been different: real rates have indeed declined, but breakeven points have expanded. This dynamic is precisely what the firm's four-mechanism framework shows as the "dollar bear market mechanism."
The research report states that the apparent shift in the Federal Reserve's monetary policy committee reaction function—initially evident in Chairman Powell's Jackson Hole speech and confirmed at last week's FOMC meeting—prioritizes protecting the labor market rather than strictly controlling above-target inflation.
Morgan Stanley says this shift has led the firm's economists to significantly revise Fed forecasts, expecting faster rate cuts to the terminal rate.
Historical data shows that under the dollar bear market mechanism, currencies rise against the dollar 67-84% of the time, with substantial average gains. The dollar bear market mechanism is notable not only for the breadth and magnitude of dollar weakness but also for its consistency.
Morgan Stanley believes the perceived shift in the Fed's reaction function increases the likelihood of remaining in the dollar bear market mechanism: as data changes, investors may think labor market weakness will trigger a larger FOMC response than expected, while upside inflation surprises may be viewed as less concerning.
Based on this assessment, Morgan Stanley has expanded its dollar "short list" to include the Australian dollar and Canadian dollar. The firm had previously recommended long EUR/USD and short USD/JPY positions. Morgan Stanley's rationale is as follows:
AUD/USD benefits from the RBA's policy risk bias toward fewer rate cuts, expected positive Australian dollar hedging flows, and relatively low risk premium compared to peer currencies.
USD/CAD benefits from its high sensitivity to interest rate differentials, market overestimation of the Bank of Canada's terminal rate, and underestimation of productivity gains from trade barrier removal.
Short Dollar Costs Will Drop Substantially
Investors commonly report that the punitive carry differential faced when shorting the dollar presents positioning challenges. Morgan Stanley emphasizes that "carry relief" is coming.
Forward rates show that for most currencies, the "cost" of short dollar positions will decrease by 50-75 basis points at some point, approaching 150 basis points for USD/JPY.
The research report states that the carry earned by dollar longs, or paid by dollar shorts, will decrease by nearly 100 basis points over the next 12 months. The firm believes this means key resistance for dollar shorts will gradually disappear.
If market pricing of the Fed's rate cutting cycle and the Fed's actual rate cuts accelerate further (likely driven by further labor market weakness), this carry dynamic could arrive sooner than expected.
Government Shutdown Risk Adds Dollar Pressure
Rising probability of a U.S. government shutdown adds new downside risk for the dollar.
Research from Morgan Stanley's economics team shows that growth slowdowns from government shutdowns typically negatively impact the dollar, and prolonged shutdowns could further increase the dollar's risk premium.
The current negative risk premium for the dollar is approximately -4%, and a government shutdown could push this figure higher. More importantly, a shutdown means suspension of government data releases, which will reduce economic data available to the Fed before its October 29th meeting.
"How the market interprets the Fed's policy decisions under insufficient data conditions, and the Fed's actual response, may lead markets to new judgments about the data sensitivity of the Fed's reaction function. If the reaction function is viewed as disconnected from data, it could further push up the dollar's risk premium."