The Federal Reserve’s campaign to raise interest rates is proving to be the US dollar’s No. 1 enemy, upending the consensus on Wall Street heading into this year.

While conventional logic suggests rising yields should support the greenback, traders are now betting that Fed policy tightening will dampen economic growth over time. Demand for dollar call options fell to a nine-month low as the currency erased its year-to-date gains. It’s putting the dollar bulls at Morgan Stanley, Bank of America and Citigroup on the defensive.

“The flattening of the yield curve suggests that the market is thinking, ‘well, because of these interest rate hikes now, growth will slow again in the not too distant future,'” said Jane Foley, change manager. strategy at Rabobank in London. “That’s going to have an influence on the dollar in the latter part of this year.”

Dollar movements are generally intertwined with the economy. The popular “dollar smile” theory suggests that its strength will follow when the US outperforms or when demand for refuge arises. The currency gained muscle during the January slump in stocks, but has since erased those gains, failing to capitalize on accelerating Fed rate hike expectations, usually a catalyst for overseas buyers in search of higher returns.

Other signs point to a waning appetite for greenbacks. The ratio of one-month puts and calls for the dollar against its major peers, while still in favor of calls, slipped to the lowest level since May, a sign that investors are not also willing to pay a premium to bet more in-the-money winnings.

With speculative positioning in the dollar still near its most bullish level since 2019, leveraged funds have started pulling some bets off the table, according to data from the Commodity Futures Trading Commission. With money market prices in a March rate hike, the Fed’s takeoff is effectively a foregone conclusion. And some investors assume that the increases have already been priced in, leaving the trade too wide.

During the stock market selloff in the second half of January, the Bloomberg Dollar Index climbed 2%, but has since given up its year-to-date gains as demand for safe havens waned. With the dollar rising primarily in times of market turmoil and not based on rate policy expectations, this could indicate that currency investors are less focused on improving carry trades and more concerned about what position Fed hawkishness could mean for the economy.

In January, the spread between two- and 10-year Treasury yields narrowed to the narrowest since October 2020. Although some of this movement, particularly for the rise in shorter-dated yields , can be attributed to the next change in interest rates, a flattening of the yield curve may be a warning that US economic growth will not be as robust as many had expected – what Treasury watchers call a bearish flattening .

“The market was not prepared for the balance sheet discussion,” said Clifton Hill, portfolio manager at Acadian Asset Management. “They had to readjust, and with a lot of the price going up in the dollar, the market started to focus on what that could potentially do for growth.”

There are signs that a slowdown in the US economy, while not imminent, is at least a possibility. Consumer confidence fell to its lowest level in more than a decade in January as inflation and the omicron variant clouded the economic outlook.

Stephen Jen, managing director of Eurizon Slj Capital, does not share this argument, however. Negative real interest rates and strong corporate earnings are boosting confidence in US growth and giving the dollar reason to rally, he said.

“You can easily understand what I’m proposing for the right side for the smile scenario once we get past the hump of this inflation profile,” Jen said.

While there hasn’t been a pronounced downtrend for the greenback yet, higher yields haven’t provided much support, said Steven Englander, head of FX research at Standard Chartered.

“Equity and growth prospects are a factor in why the curve continues to flatten,” he said. .”