Bets that the dollar will continue to decline have become a popular trade in recent days.

Due to the worldwide economic woes, short positions against the dollar have grown substantially over the past four months, leading some to believe that positions could be squeezed.

Negative sentiment from COVID-19 isn’t going away anytime soon along with the corresponding stimulus packages that have flooded the market with greenbacks. Analysts speculate that investors must be heavily shorting (selling) the dollar.

However, short positions have grown so substantial that any uptick in the American currency could force shorts to close out positions. This buying pressure would push prices up, causing additional short position closures, and further price increases. Such an event is often called a ‘short squeeze’.

A wild ride for the dollar against a basket of currencies in 2020 – DXY | Source: TradingView

Net Positives Globally

The dollar is so oversold that other currencies are witnessing some positives for the first time, in a long time. The euro and yen both recorded gains against the dollar – an event that hasn’t happened in over two years.

This net-positive positioning could also signal an opportunity for the dollar to regain some of what it has lost. However, the greater risk appears to be market volatility, which could drive short-sellers out. According to George Boubouras, head of research at K2 Asset,

Excess spikes in volatility could see the dollar swing back aggressively in the short-term. That could prove painful especially for some emerging-markets that tend to get whacked on bouts of dollar strength.

Short-Term Gain, Long-Term Pain

While the potential for a short squeeze is strong in the immediate term, the long-term outlook remains bleak. A flood of liquidity, coupled with the weakening American economy simply cannot be overcome by market swings.

Over the last decade, history has shown that August is traditionally a season when the world moves into the dollar, pushing prices up. However, even the seasonal push reflects a very small positive shift when compared with the other factors already in play.

The vast majority of indicators suggest that the U.S. economy will not see a rebound for some time. Investors have flooded into hedge positions, seeking protection from economic downturns.

Gold’s spike over $2,000, bitcoin’s recent rise above $10,000, and plummeting Treasury yields all show weakness at hand. The dollar could very well be the next domino to fall.

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