Sunday, January 16

Everybody is a dollar bull as the taper makes the US currency a prime bet


The dollar is poised to hit new highs in the coming months as an anticipated reduction in stimulus from the Federal Reserve, seasonal demand, and energy-driven instability unleash a wave of bullish bets on the currency.

Evidence of the dollar’s dominance is rampant as inflationary pressures lift yields and stagflation concerns polish its safe-haven credentials. It is at the highest level since December 2018 against the yen, while CFTC data shows that the leveraged funds are the most optimistic in more than a year. Traders are paying more to hedge against gains than declines, at levels last seen around the first wave of the pandemic, based on option prices for members of the Bloomberg Dollar Index.

Not even a disappointing September US employment report derailed the currency, because traders are still expecting the Fed to start cutting asset purchases this year. In fact, the market interpreted the inflationary signals in the report as further proof that US interest rates would have to rise sooner rather than later, pushing yields and the dollar higher.

Fed funds futures now imply a 95% chance of a rate hike by November 2022, and the odds are essentially a late September coin flip.

The sustained strength of the world reserve currency runs the risk of unleashing a wave of capital flows in the markets. That could further sour the risk appetite already under pressure as high energy prices fuel 1970s-style stagflation anxiety. Sentiment towards the dollar was negative at the beginning of the year. prompting investors to recalculate their bets as the dollar rose.

Rabobank’s Jane Foley is among strategists who say the dollar is poised to gain more as yields rise and demand for emerging market assets remains low. Saxobank’s John Hardy believes the dollar could “make life miserable for bears in the fourth quarter,” and predicts that the market will finally start to get serious about the Fed’s downsizing.

Comrades behind

Most strategists expect the dollar to be particularly strong against low-interest currencies like the euro and the yen, because their central banks are expected to lag behind the Fed in raising rates.

“We’re getting a little closer to that declining narrative in the US, and those other funding currencies are still a considerable distance away,” CIBC’s Jeremy Stretch said in an interview with Bloomberg TV on Monday. “Central banks like the ECB will probably be on hold for the next two or three years, so ultimately it favors long dollar positions.”

Two-year US Treasuries currently yield about 100 basis points more than their European counterparts and 45 more than Japanese debt. For 10-year bonds, the yield difference is 173 basis points for the euro region and 152 for Japan.

That has left analysts chasing currency and bond movements, with ICE’s dollar index and 10-year Treasury yields already above consensus forecasts for the end of the year.

Last refuge?

This year’s high for the dollar was set in September, as investors sought safety as risk assets were hit by the turmoil in China’s real estate sector and the combination of slowing global growth and accelerating inflation. It could get another boost from protection demand as the energy crisis continues to shake markets.

The unprecedented spike in energy prices has also been a key driver of the dollar and has affected the euro, according to Kevin Thozet, a member of Carmignac’s investment committee. You have been increasing your exposure to the dollar for the past month.

“The move is likely related to what is happening on the commodity side,” he said. “Because the United States is self-sufficient on that front, and it is not the same for the euro area.”

The euro-dollar pair has been hovering around lows not seen since July 2020, in part due to the growing strength of the dollar. Speculators have been undoing long euro bets since the second half of last year, and last week positions turned more negative since March 2020.

The pullback, weakening global growth forecasts combined with rising inflation make the greenback an even more attractive bet, JPMorgan’s Meera Chandan wrote in a research note on Friday. “The backdrop lends itself to holding dollars on a broad basis, not only against higher beta currencies that are typically growth sensitive, but also relative to other defensive currencies like JPY.”

The dollar as a refuge is a relatively new phenomenon. When times are tough globally, currency traders have historically looked to the Japanese yen and the Swiss franc for stability. But with unbeatable liquidity and a growing yield advantage, the US currency has become an attractive place to store value during market turmoil, according to CIBC’s Stretch.

“Investors are looking for some degree of safety and security, and I think in that context, from a foreign exchange perspective, it brings us back to that broader dollar narrative,” Stretch said.

Fed policy will likely give the dollar an edge over the next few months, and not just against traditional havens, according to Mazen Issa, senior currency strategist at TD Securities. The dollar also tends to benefit from a seasonal advantage against other G-10 currencies in the fourth quarter, he said.

“Is the dollar a safe haven? With the backdrop, perhaps so. But I think it’s more about the change in monetary policy risks, ”Issa said. “It seems that now it is necessary to respect the dollar.”

© 2021 Bloomberg


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