In a recent global foreign exchange strategy report released by UBS, the current state of the dollar against the backdrop of a turbulent economic and financial market landscape has come under scrutinyThe analysis highlights that positions favoring the dollar are facing mounting pressures, signaling a potential shift in market sentiment and positioning.

The report, dated February 17, points to data from the Commodity Futures Trading Commission (CFTC) indicating that bullish positions on the dollar are under the most significant selling pressure since October 2024. While the net long positions in dollars have been notably reduced from previous peaks, they remain at historically elevated levelsSimultaneously, short positions on the euro have decreased roughly 55% from their highs in December, suggesting a potential unwinding of these positions by hedge funds, especially noticeable during North American trading hours.

UBS analysts further observe that the spot exchange rate of the euro against the dollar has made a notable bounce back towards approximately 1.05. Their short-term fair value estimate has been revised upwards from 1.05 to 1.06, predominantly driven by an upturn in European yieldsThe report posits that the 1.0650 level may represent the ceiling for the euro-dollar exchange rate in the first quarter, potentially marking an opportune entry point for contemplating new short positions on the euro against the dollar.

In contrast to the dollar’s struggles, the Japanese yen has displayed unexpected strength despite a generally positive risk appetite in the marketsUBS indicates that the yen's beta coefficient relative to stock markets has reached historical highs, which typically contradicts its safe-haven characteristicsA dual effect seems to play a role here: on one side, the anticipation of a hawkish shift in the Bank of Japan's monetary policies is gaining traction, with market expectations for tightening intensifyingYet, the fluctuation of the yen appears to be outpacing the implied changes in the interest rate market, suggesting that there is additional positive capital flow sustaining the yen.

On the flip side, repatriation of Japanese capital is intensifying

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According to data from Japan’s Ministry of Finance, Japanese investors have recorded three consecutive months of net selling in foreign bonds, amounting to 3 trillion yen, primarily driven by banks and life insurance companiesEven though the current capital influx is still below levels seen during 2022 and 2023, its persistence may act as a catalyst for further yen appreciation in the near term.

Drawing from this analysis, UBS has maintained its bearish stance on the euro against the yen, while also advocating for shorts on other yen-cross rates including the Swiss franc to the yen and the British pound to the yenThe report indicates that rising domestic yields in Japan could further amplify capital repatriation, alongside additional liquidity pressures on the yen, offering significant downward potential for yen-cross rates.

The report also highlights that the Canadian dollar has surpassed its fundamental value, with UBS's short-term fair value model suggesting a dollar against the loonie valuation of 1.44, implying that the Canadian dollar could face some downward correction pressures ahead.

Beyond the primary currency pairs, the report delves into the dynamics surrounding other currencies influenced by macroeconomic factors and market sentimentsFor instance, fluctuations in the British pound against the dollar or the Swiss franc against the dollar, as well as the Australian dollar and New Zealand dollar against the dollar, are all significantly impacted by overarching economic developments and prevailing market emotions.

Further exploration in the report focuses on how macroeconomic factors shape the currency markets, casting light on the policy directions of major central banks, interest rate disparities, and growth forecastsUBS has employed a macro factor attribution analysis to unveil the contributions of various economic elements to currency fluctuations, detailing how policy shifts and economic data from major economies, including the Eurozone, the U.S., and Japan, exert influence on exchange rates.

The report does not shy away from discussing seasonal factors and short-term fair value models in exhaustive detail, offering a comprehensive market outlook for investors

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