The rapid rise in interest rates in the United States, the relative stability of the American economy and the demand for shelter in the hope of finding protection from turbulence in financial markets pushed investors to the dollar.
Since the beginning of the year, the greenback has already strengthened by about 19% against its main competitors.
Some market participants are concerned that the increased demand for USD has made it overbought, which increases the risk of a sharp decline if the arguments in favor of owning the US currency change and traders try to close their positions all at once.
Morgan Stanley estimates that, with the exception of a short period of peak uncertainty associated with the pandemic, long positions in US dollars are the most stretched in history.
About 56% of global fund managers who took part in a survey conducted by Bank of America in September called long positions on USD the most "overvalued transaction", and for the third month in a row, the greenback holds this position in the survey.
"If we get a catalyst, the dollar may turn around, and turn around very aggressively," BNP Paribas strategists said.
A reduction in the volatility of interest rates in the United States, the normalization of European energy prices and China's refusal from its zero-COVID-19 policy are three prerequisites for the dollar to enter the bear market, analysts at BNP Paribas believe.
"When all these three points are met, it will give us a better chance to see how the greenback will enter the bear market, but we do not think that this will happen in the near future," they said.
According to experts, until there are sharp changes in the fundamental picture and the Federal Reserve's rhetoric, it is definitely not worth selling USD.
Further growth of volatility in financial markets will contribute to the strengthening of the dollar due to its status as a safe haven, Commonwealth Bank of Australia analysts believe.
Wall Street plunged into a bear market on Monday, and the dollar was at the peak of demand.
"Wall Street can easily take another step down, as classic signs of market capitulation, such as the VIX index reaching the key level of 40, have not happened – although we are getting closer," said analysts at Invesco.
The VIX index, also known as the "fear indicator" of Wall Street, reached a three-month high of 32.88 points the day before.
The main US stock indexes continued to decline on Monday after falling at the end of the previous week. Thus, the value of the S&P 500 dropped by 1.03% to 3655.04 points, which was below the June low of 3665 points.
Meanwhile, on Monday, the USD index rose to the highest level since May 2002 in the area of 114.60 points.
"Judging by the feelings, the prerequisites for the continuation of chaotic movements in the markets still remain," said strategists at CIBC Capital Markets, adding that the driver of these movements will be the strength of the dollar, which, in turn, depends on how aggressively the Fed will raise interest rates.
The S&P 500 index has fallen 12% in just a month after Fed Chairman Jerome Powell delivered a stern statement at a central bank symposium in Jackson Hole about the economic "pain" needed to contain the fastest price growth since the 1980s.
"There is a lot of uncertainty about how quickly inflation will decrease, and there is also a lot of uncertainty about whether the Fed will conduct such an aggressive tightening campaign, which they announced recently," Blackrock analysts said.
In recent weeks, FOMC officials have been adamant that they are willing to raise rates as much as necessary to lower inflation – even at the cost of rising unemployment and a possible recession.
"It will be painful, and unemployment will rise, but in order to reduce inflation, we will simply have to raise rates, and they will be held at a higher level for longer than we previously thought," Cleveland Fed President Loretta Mester said on Monday.
She said she would like to see a few months of lower inflation before making sure that inflation has peaked.
Meanwhile, the head of the Boston Fed, Susan Collins, reiterated the Fed's view that the fight to cool the current surge in inflation is of paramount importance.
"At the moment, inflation remains too high. Although the rate of price growth may indeed be at or close to its peak, the return of inflation to the target indicator will require further tightening of credit conditions, which the US central bank influences by raising the target rate on federal funds," Collins said.
Last week, the Fed approved the third consecutive rate hike by 75 basis points, raising its discount rate by a total of three percentage points this year, which was one of the fastest attempts to raise the cost of borrowing to ease inflationary pressures.
"Further rate hikes will be required in order to bring inflation under control. The Fed's determination is the most important factor supporting the dollar. It should be noted that the greenback is trading at record levels on a trade-weighted basis. However, the current exchange rate levels are fundamentally justified," Commerzbank economists believe.
The continued strengthening of the dollar does not bring anything good to global financial markets, analysts at Morgan Stanley believe.
"According to our estimates, a 1% change in the dollar exchange rate affects the S&P 500 profit growth by 0.5%. S&P 500 earnings in the fourth quarter, all other things being equal, will face about a 10% barrier to growth," they said.
Morgan Stanley believes that the bearish stock market will not end until the S&P 500 reaches the 3000-3400 range later this fall.
Investors should buckle up and prepare for an even bigger drop in the already battered stock market, CFRA Research strategists warn.
"We think it will be a bear market with a recession. Bear markets with a recession were deeper and lasted longer than falls without a recession, with an average drop of 35%. Therefore, we think that we will probably eventually see the "bottom" of this bear market around 3,200 points," they said.
According to CFRA Research's forecast, the S&P 500 index will decline by another 12% compared to current levels. And if the bears are successful, this will mean a drop of about 33% from the record high recorded on January 3, 2022.
The world's three largest economies – the United States, China and the eurozone – are slowing sharply, and even a moderate blow to the global economy over the next year could lead to its recession, according to a recent World Bank study.
Therefore, it is not surprising that fear and anxiety persist among market participants, which favors the dollar, as investors are looking for a safe haven.
On Tuesday, the S&P 500 attempted to grow at the beginning of trading in New York, but it was unsuccessful, as a result of which the index was again in negative territory.
The rally in stocks faltered after Fed policymakers called for further interest rate hikes, even despite the risk of slowing economic growth.
The rapid increase in interest rates in the United States has increased the risk of recession, but this is likely to be caused by an external shock, and not by the collapse of the American economy, which remains stable, St. Louis Fed President James Bullard said on Tuesday.
"Every time you try to walk between buildings on a tightrope, you worry that a strong wind will rise," said Bullard, referring to the path that the Fed is trying to follow by controlling inflation in the United States without causing a serious economic downturn.
"With strong job growth in America and strong household balance sheets, talk of a recession should be conducted on a global basis rather than in the United States," the head of the St. Louis Fed said, pointing to the possibility that Europe and China will pull the rest of the world into an economic downturn.
Chicago Fed President Charles Evans, in turn, said that the US central bank will need to raise rates by at least another percentage point this year.
"Our actions will lead to economic growth below trend and a weakening of the labor market. However, the inability to restore price stability will lead to much greater costs," he said.
These comments put pressure on stock prices and allowed the dollar to shrug off intraday losses.
After a short correction, the greenback returned to growth, rising above 114 again and leaving the EUR/USD pair in the background.
It plunged by more than 80 points on Monday and registered the lowest daily close since June 2002 at 0.9605.
EUR/USD tried to launch a recovery on Tuesday, but encountered strong resistance in the 0.9650-0.9670 area, after which it rolled back.
"The events in Ukraine have only reinforced the Fed's inflation concerns, while hitting the prospects for economic growth in Europe. In short, do not wait for a reversal in the EUR/USD pair until the Fed finishes its work – and this does not seem to happen until the first quarter of 2023," ING analysts said.
"We believe that the 0.9700 level will stop any EUR/USD rally, and we doubt that the ECB's hawkish comments will change the situation much," they added.
ECB President Christine Lagarde said that the central bank expects to continue tightening monetary policy over the next few meetings in order to reduce demand in the economy and protect against the risk of a constant increase in inflation expectations.
"A tighter monetary policy, which raises concerns for economic growth and financial stability, is unlikely to cause a rise in the euro, whether indirectly or directly," Morgan Stanley analysts believe.
The eurozone's GDP is likely to decline in the fourth quarter of 2022 and the first quarter of 2023. The entirety of next year will be difficult, but it is not yet clear whether there will be a recession following its results, Lagarde said.
"Given the level of uncertainty we face, it is difficult to predict what the real outcome of 2023 will be. But it will, of course, be a difficult year, the first quarter of which is likely to be negative. And the fourth quarter of 2022, as we believe, will be negative," she said.
The baseline scenario of Bloomberg economists assumes a 1% drop in eurozone GDP, with the recession projected to begin in the fourth quarter. If the coming months become particularly cold and the 27 members of the European Union are unable to efficiently distribute scarce fuel reserves, the reduction could be up to 5%, experts warn.
"If consumer behavior turns out to be unstable and unity between EU countries begins to break down, gas prices may jump above €400, inflation may approach 8% next year, and the economy may shrink by almost 5% this winter," they said.
As soon as Beijing eases restrictions related to COVID-19, Chinese demand for LNG will grow, which will lead to increased competition and increased price pressure for Europe, JPMorgan Chase strategists believe.
"This is not just a three-month problem. Potentially, this is a two-year problem," said the staff of the Oxford Institute for Energy Research.
Sentiment towards the single currency remains weak amid the volatility of gas prices, as Europe prepares for winter in conditions of limited supplies of blue fuel. This will worsen the economic prospects of the eurozone, which are already weak, given the lack of a long-term solution to the current energy crisis, according to ANZ Bank economists.
"We think that any recovery of the eurozone economy will be difficult and uncertain until the second quarter of 2023, when the winter season ends. We have updated our forecasts for EUR/USD and expect that in the second quarter of 2023 it will find the bottom around the 0.9500 mark," they said.
Thus, there is reason to believe that any short-term growth of the main currency pair is likely to be a technical correction. At the same time, periodic bouts of weakness of the US currency can be considered as a convenient opportunity for its longs.