Each day there is growing conviction
The buck is due further affliction
More views now exist
The Fed will soon ‘Twist’
Thus, slaking the market’s addiction
But even if Powell and friends
Do act as the crowd now contends
Does anyone think
Lagarde will not blink
And cut rates at which her group lends?
You cannot read the financial press lately without stumbling across multiple articles as to why the dollar is due to fall further. There is no question it has become the number one conviction trade in the hedge fund community as well as the analyst community. There are myriad reasons given with these the most common:
1. The introduction of the vaccine will lead to a quicker recovery globally and demand for risk assets not havens like the dollar
2. The Biden administration will be implementing a new, larger stimulus package adding to the global reflation trade
3. The Fed is going to embark on a new version of Operation Twist (where they swap short-dated Treasuries for long-dated Treasuries) in order to add more stimulus, thus weakening the dollar
4. The market technical picture is primed for further dollar weakness in the wake of recent price action breaking previous dollar support levels.
Let’s unpack these ideas in order to try to get a better understanding of the current sentiment.
The vaccine story is front page news worldwide and we have even had the first country, the UK, approve one of them for use right away. There is no question that an effective vaccine that is widely available, and widely taken, could easily alter the current zeitgeist of fear and loathing. If confidence were to make a comeback, as lockdowns ended and people were released from home quarantines, it would certainly further support risk appetite. Or would it?
Consider that risk assets, at least equities, are already trading at record high valuations as investors have priced in this outcome. You may remember the daily equity rallies in October and November based on hopes a vaccine would be arriving soon. The point is, it is entirely possible, and some would say likely, that the vaccine implementation has already been priced into risk assets. One other fly in this particular ointment is that so many businesses have already permanently closed due to the government-imposed restrictions worldwide, that even if economic demand rebounds, supply may not be available, thus driving inflation rather than activity.
How about the idea of a new stimulus package adding to global reflation? Again, while entirely possible, if, as is still widely expected, the Republicans retain control of the Senate, any stimulus bill is likely to disappoint the bulls. As well, if this is US stimulus, arguably it will help support the US economy, US growth and extend the US rebound further and faster than its G10 and most EMG peers. Yes, risk will remain in favor, but will that flow elsewhere in the world? Maybe, maybe not. That is an open question.
Certainly, a revival of Operation Twist, where the Fed extends the maturity of its QE purchases in order to add further support to the economy by easing monetary policy further would be a dollar negative. I thought it might be instructive to see how the dollar behaved back in 2011-12 when Ben Bernanke was Fed Chair and embarked on the first go-round of this policy. Interestingly enough, from September 2011 through June 2012, the first leg of Operation Twist, the dollar rallied 8.7% vs. the euro. When the Fed decided to continue the program for another six months, the first dollar move was a continuation higher, with another 2.75% gain, before turning around and weakening about 6%. All told, through two versions of the activity, the dollar would up slightly firmer (2.5%) than when it started.
And this doesn’t even consider the likelihood that if the Fed eases further, all the other major central banks will be doing so as well. Remember, FX is a relative game, so relative monetary policy moves are the driver, not absolute ones. And once again, I assure you, that if the euro starts to rally too far, the ECB will spare no expense to halt that rally and reverse it if possible. Currently, the trade-weighted euro is back to levels seen in early September but remains 1.75% below the levels seen in 2018. It is extremely difficult to believe that the ECB will underperform next week at their meeting if the euro is climbing still higher. Deflation in Europe is rampant (CPI was just released at -0.3% in November), and a strong currency is not something Lagarde and her compatriots can tolerate.
Finally, looking at the technical picture, it may well be the best argument for further dollar weakness. To the uninitiated (including your humble author) the variety of technical indicators observed by traders can be dizzying. However, some include satisfying the target of an “inverted hammer” pattern, recognition of the next part of an Elliott Wave ABC correction and DeMark targets now formed for further dollar weakness. While that mostly sounded like gibberish, believe me when I say there are many traders who base every action on these indicators, and when levels are reached in the market, they swarm in to join the parade. At the same time, the hedge fund community, while short a massive amount of dollars, is reputed to have ample dry powder to increase those positions.
In sum, ironically, I would contend that the technical picture is the strongest argument for the dollar to continue its recent decline. Risk assets are already priced for perfection, the vaccine is a known quantity and any Fed move is likely to be matched by other central banks. This is not to say that the dollar won’t decline further, just that any movement is likely to be grudging and limited. The dollar is not about to collapse.
A quick recap of today’s markets shows that risk appetite, not unlike yesterday’s lack of enthusiasm, remains satisfied for now. Asian equities were mixed with the Hang Seng (+0.7%) the leader by far as both the Nikkei (0.0%) and Shanghai (-0.2%) showed no life. European bourses are mostly lower (DAX -0.4%, CAC -0.25%) although the FTSE 100 is flat on the day. And US futures are also either side of flat.
Bond markets, are rebounding a bit from their recent decline, with Treasuries seeing yields lower by 1 basis point and European bonds all rallying as well, with yields falling between 2bps and 3bps. The latter may well be due to the combination of weaker than expected Services PMI releases as well as the news that Germany is extending its partial lockdown to January 10. (Tell me again why the euro is a good bet here!)
Gold continues to rebound from its correction last week, up another $10 while the dollar, overall, this morning is somewhat softer, keeping with the recent trend. GBP (+0.6%) is the leading gainer in the G10 on continued hopes a Brexit deal will soon be reached, but the rest of the bloc is +/-0.2%, or essentially unchanged. EMG gainers include HUF (+0.7%) as the government there expands infrastructure spending, this time on airports, while the rest of the bloc has seen far smaller gains, which seem to be predicated on the idea of US stimulus talks getting back on track.
Initial Claims (exp 775K) data leads the calendar this morning with Continuing Claims (5.8M) and then ISM Services (55.8) at 10:00. Yesterday’s Beige Book harped on the negative impact that government shutdowns have had on companies with no sign, yet, of vaccine hopes showing up in businesses. At the same time, Chairman Powell, in his House testimony yesterday, explained that there was no rift between the Fed and the Treasury, and the Fed response when Treasury Secretary Mnuchin said he was recalling unused funds from the CARES act, was merely reinforcement of the idea that the Fed was not going to back away from their stated objectives.
In the end, the dollar remains under pressure and the trend is your friend. With that in mind, though, it strikes that a decline of more than another 1%-2% will be very difficult to achieve without a more significant correction first. Again, for receivables hedgers, these are good levels to consider.
Good luck and stay safe