Bearish bets on the US dollar have increased sharply since the beginning of this year. As the dollar index, a measure of the greenback against a basket of its peers, plunged more than 10 per cent between late March and the end of August, short positions against the currency rose to their highest level since the end of 2017, data from Bloomberg shows. Some of the arguments in favour of a weaker dollar remain compelling. The most persuasive one is the unprecedented measures taken by the Federal Reserve in response to the damage wrought by Covid-19. By slashing interest rates close to zero, expanding its balance sheet dramatically and setting up a range of credit facilities to shore up the financial system, the Fed has stripped the dollar of most of its yield advantage over its peers and fuelled concerns about currency debasement. The greenback looked particularly vulnerable during the summer, when a resurgence of Covid-19 cases in several large US states forced governments to roll back plans to reopen their economies, threatening America’s fragile recovery. A highly unpredictable presidential election was, at the time, perceived by many traders as an additional reason to be bearish on the dollar. Yet, as election day draws near, the risks related to the outcome of the vote – an event which historically has rarely acted as a catalyst for a major sell-off – are coming under intense scrutiny. This is happening at a time when volatility in many asset classes is increasing, exacerbated by a second wave of the virus in Europe, which, according to survey data, has caused the rebound in economic activity to falter. Since the end of August, the dollar index has risen 1.8 per cent, its strongest rally since early April. While it is too soon to say whether this marks the start of a sustained appreciation, the traditional role of the world’s dominant reserve currency as a refuge in times of turmoil is beginning to reassert itself. The risk of a contested election – a scenario which is being taken more seriously since US President Donald Trump refused to commit to an orderly transfer of power if he loses the vote, and which was thrown into sharp relief by Tuesday’s acrimonious television debate between Trump and his Democratic opponent Joe Biden – is moving markets. The clearest indication is in futures contracts tied to the VIX Index, Wall Street’s “fear gauge” which shows the anticipated volatility of the S&P 500 equity index. The contracts are pricing in an unusually high level of anxiety in the months following the November 3 election, suggesting that many traders are increasingly concerned about a messy, disputed outcome that could lead to a full-blown constitutional crisis. Such a scenario could put the dollar under renewed strain if the surge in US political risk becomes the main driver of sentiment. Yet, the combination of excessively bearish wagers on the dollar, mounting threats to the global recovery and, crucially, the greenback’s safe haven appeal – even when the source of the volatility is in the United States itself – is likely to benefit the currency in the coming months. Indeed, the dollar’s rebound is part of a broader reappraisal of the global economic and political landscape as the pandemic continues to rage. One of the reasons the greenback fell sharply earlier this year is because many investors believed the global recovery, notably in Europe, was gaining momentum. Massive monetary stimulus in the US, coupled with signs of reflation elsewhere, underpinned a bearish outlook for the dollar. China’s foreign currency saving rates slashed to record lows These assumptions are now being seriously questioned. Not only did the Fed disappoint markets at its policy meeting on September 16, when it failed to unveil new measures to help it meet its 2 per cent inflation target, the euro zone’s services sector slipped back into contraction territory last month. As JPMorgan noted in a report published on September 25, “a summer supportive of grinding reflation trades [is] giving way to a more dollar-supportive and risk-threatening backdrop into year-end”. From a positioning standpoint, there is ample scope for the dollar to strengthen further, given that this year’s huge build-up in bets against the currency has barely begun to unwind. Investors, who were overly optimistic about the global recovery, and who underestimated the haven appeal of the world’s reserve currency, could be in for a lot more pain. The dollar’s prospects hinge largely on what happens on the morning of November 4. While Biden remains the firm favourite to win the election, his lead in an average of polls compiled by Real Clear Politics is just 6.5 points. More worryingly, Trump, who has fiercely criticised the use of mail-in voting, has created a pretext for contesting the result. The conditions for a disputed election are ripe. While the catalyst for a sustained rally in the dollar has yet to fully emerge, America’s perilous election has already shown that a weaker greenback is no longer a one-way bet. Nicholas Spiro is a partner at Lauressa Advisory