The US dollar has entered a "bear market mechanism"! Morgan Stanley: Short-selling costs will drop significantly, the Federal Reserve is key, and a government shutdown is a "potential bearish factor."

The US dollar may experience sustained and broad-based sell-offs—this is Morgan Stanley’s latest assessment, which also sees a government shutdown as a “potential bearish” factor for the dollar.

On September 23, according to Chasewind Trading Desk, Morgan Stanley said in its latest research report that the US dollar has entered a “bear market regime,” which is expected to last longer, resulting in widespread selling pressure on the dollar.

Morgan Stanley strategist David S. Adams believes that after Powell’s Jackson Hole speech, the Fed has clearly shifted to prioritize protecting the labor market, even at the cost of tolerating inflation above its target. This policy shift provides ongoing momentum for the dollar bear market.

Morgan Stanley pointed out, crucially, that market pricing shows the dollar’s interest rate differential advantage will drop by nearly 100 basis points over the next 12 months, which will significantly lower the cost of shorting the dollar.

The risk of a US government shutdown is rising, and Morgan Stanley believes this poses a potential bearish factor for the dollar. Polymarket data shows the probability of a shutdown has recently increased significantly, which may further increase the dollar’s risk premium.

Fed policy shift triggers dollar bear market regime

Morgan Stanley had forecasted continued dollar weakness in its mid-year outlook, but at the time, the most likely market regime was expected to be a “defensive regime,” where real rates and breakevens both decline.

However, since May, the reality has been different: real rates have indeed declined, but breakevens have expanded. This dynamic is exactly what the firm’s four-regime framework describes as a “dollar bear market regime.”

The report states that there has been a clear shift in the Fed’s monetary policy committee’s reaction function—first appearing in Chairman Powell’s Jackson Hole speech and confirmed in last week’s FOMC meeting—that is, prioritizing the labor market instead of strictly controlling inflation above target.

Morgan Stanley said this shift led its economists to sharply revise their Fed forecast, now expecting faster rate cuts to the terminal rate.

Historical data shows that under the dollar bear market regime, the frequency of various currencies rising against the dollar is 67–84%, with considerable average gains. The dollar bear market regime is not only notable for the breadth and magnitude of weakness, but also for its consistency.

Morgan Stanley believes that the perceived shift in the Fed’s reaction function increases the likelihood of remaining in the dollar bear market regime: as data change, investors may believe labor market weakness will trigger a larger-than-expected FOMC response, while inflation surprises to the upside may be seen as less concerning.

Based on this judgment, Morgan Stanley has expanded its "dollar short list" to include the Australian dollar and Canadian dollar. Previously, the firm had already recommended long EUR/USD and short USD/JPY positions. Their rationale is as follows:

AUD/USD benefits from the RBA’s policy risk being skewed less toward rate cuts, expected positive hedging flows into AUD, and relatively lower risk premium versus peer currencies.

USD/CAD benefits from its high sensitivity to rate differentials, the market’s overestimation of the Bank of Canada’s terminal rate, and underestimation of productivity gains from the removal of trade barriers.

Cost of shorting the dollar will drop significantly

Investors widely report that the punitive interest rate differential for shorting the dollar is a challenge to holding positions. Morgan Stanley emphasizes that “rate differential relief” is coming soon.

Forward rates show that for most currencies, the “cost” of shorting the dollar will drop by 50–75 basis points at some point, and for USD/JPY, nearly 150 basis points.

The report says that the carry received by dollar longs, or paid by dollar shorts, will decrease by nearly 100 basis points over the next 12 months. The firm believes that this means the key resistance to dollar shorts will gradually disappear.

If market pricing for the Fed’s rate cut cycle and the actual Fed rate cut process accelerates further (most likely driven by further labor market weakness), these rate differential dynamics could arrive sooner than expected.

Government shutdown risk adds pressure to the dollar

The rising probability of a US government shutdown adds a new downside risk to the dollar.

Morgan Stanley’s economics team research shows, the growth slowdown typically caused by a shutdown is usually negative for the dollar, and a prolonged shutdown could further increase the dollar’s risk premium.

Currently, the dollar’s negative risk premium is about -4%, and a shutdown could push this higher. More importantly, a shutdown means the release of government data will be suspended, reducing the economic data the Fed will have before its October 29 meeting.

“How the market interprets the Fed’s policy decisions without sufficient data, and the Fed’s actual response, could lead the market to reassess the Fed’s data sensitivity. If the reaction function is seen as decoupled from the data, this could further raise the dollar’s risk premium.”

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The above highlighted content is from Chasewind Trading Desk.

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