Just last week the narrative spoke
And told us the world would soon choke
On dollars they held
Thus, would be compelled
To sell them, ere they all went broke
But funnily, this week it seems
The selling had reached its extremes
So, shorts are now squeezed
And traders displeased
As they now must look for new themes
It had been the number one conviction trade entering 2021, that the dollar would sell off sharply this year. In fact, there were some who were calling for a second consecutive year of a 10% decline in the dollar versus its G10 counterparts, with even more gains in some emerging market currencies. The market, collectively, entered the new year short near record amounts of dollars, riding the momentum they had seen in Q4 of last year and looking for another few percentage points of decline. Alas, one week into the year and things suddenly seem quite different.
The first thing to highlight is that while a few percent doesn’t seem like much of a move, certainly compared to equities or bitcoin, the institutional trading community, consisting of hedge funds and CTA’s, lever up their positions dramatically. In fact, 10x capital is quite common, with some going even further. So, that 2% move on a 10x leverage position results in a 20% gain, certainly very respectable. The second thing to highlight is that if a short-term trading reversal is able to cause this much angst in the trading community, conviction in the trade must not have been that high after all.
But let us consider what has changed to see if we can get a better understanding of the market dynamics. Clearly, the biggest change was the run-off election in Georgia, which had been expected to result in at least one seat remaining in Republican hands, and thus a Republican majority in the Senate. This outcome of a split government was seen to be a general positive for risk, as it would prevent excessive increases in debt financed stimulus, thus force the Fed to maintain low US interest rates. And of course, we all know, that low rates should undermine the currency.
But when the Democrats won both seats, and the Senate effectively flipped, the new narrative was that there would be massive stimulus forthcoming, encouraging the reflation trade. The thing is, the reflation trade is part and parcel of the steepening yield curve trade based on the significant amount of new Treasury debt that would need to be absorbed by the market, with the result being declining prices and higher Treasury yields. (One thing that I never understood about the weak dollar trade in this narrative was the idea that a steeper yield curve would lead to a weaker dollar, when historically it was always the other way around; steep curve => strong dollar.)
Last week, of course, we saw Treasury yields back up 20 basis points in the back end of the curve, exactly what you would expect in a reflation trade. And so, it cannot be surprising that the dollar has found a bottom, at least in the short-term, as higher yields are attracting investors. But what does this say about the future prospects for the dollar?
My thesis this year has been the dollar will decline on the back of declining real yields in the US, which will be driven by rising inflation and further Fed support. Neither the US, nor any G10 country for that matter, can afford for interest rates to rise as they continue to issue massive amounts of debt, since higher rates would ultimately bankrupt the nation. However, inflation appears to be making a comeback, and not just in the US, but in many places around the world, specifically China. Thus, the combination of higher inflation and capped yields will result in larger negative real rates, and thus a decline in the dollar. Last week saw real yields rise 15 basis points, so the dollar’s rally makes perfect sense. But once the Fed makes it clear they are going to prevent the back end of the curve from rising, the dollar will come under renewed pressure. However, that may not be until March, unless we see a hiccup in the equity market between now and then. For now, though, as long as US yields rise, look for the dollar to go along for the ride.
Of course, higher US yields and a stronger dollar do not encourage increased risk appetite, so a look around markets today shows redder screens than that to which we have become accustomed. The exception to the sell-off rule was Tokyo, where the Nikkei (+2.35%) rallied sharply as the yen continues to weaken. Remember, given the export orientation of the Japanese economy, a weaker yen is generally quite positive for stocks there. The Hang Seng (+0.1%) managed a small gain, but Shanghai (-1.1%), fell after inflation data from China showed a much larger rebound than expected with CPI jumping from -0.5% to +0.2%. Obviously, that is not high inflation, but the size and direction of the move is a concern.
European markets, however, are all underwater this morning, with the DAX, CAC and FTSE 100 all lower by 0.5%. US futures are pointing down as well, between 0.4%-0.6% to complete the sweep. Bond markets are modestly firmer this morning, with Treasury yields slipping 1.5 bps, while Bunds, OATS and Gilts have all seen yields fall just 0.5bps. Do not be surprised that yields for the PIGS are rising, however, as they remain risk assets, not havens.
In the commodity space, oil is under modest pressure, -0.65%, while gold is essentially unchanged, although I cannot ignore Friday’s 2.5% decline, and would point out it fell another 1.5% early in today’s session before rebounding. Since I had highlighted Bitcoin’s remarkable post-Christmas rally, I feel I must point out it is down 17% since Friday, with some now questioning if the bubble is popping.
Finally, the dollar continues its grind higher, with commodity currencies suffering most in the G10 (NOK -1.1%, NZD -0.7%, AUD -0.6%) as well as the pound (-0.6%) which is feeling the pain of Covid-19 restrictions sapping the economy. In the EMG space, we are also seeing universal weakness, with the commodity focused currencies under the most pressure here as well. So, ZAR (-1.0%), MXN (-0.85%) and BRL (-0.8%) are leading the pack lower, although there were some solid declines out of APAC (IDR -0.75%, KRW -0.7%) and CE4 (PLN -0.75%, HUF -0.7%).
On the data front, this week brings less info than last week, with CPI and Retail Sales the highlights:
|Tuesday||NFIB Small Biz||100.3|
|JOLTs Job Openings||6.5M|
|Wednesday||CPI||0.4% (1.3% Y/Y)|
|-ex food & energy||0.1% (1.6% Y/Y)|
|Fed’s Beige Book|
|PPI||0.3% (0.7% Y/Y)|
|-ex food & energy||0.1% (1.3%)|
Aside from that, we also will hear a great deal from the Fed, with a dozen speakers this week, including Powell’s participation in an economics webinar on Thursday. Last week, you may recall that Philadelphia’s Patrick Harker indicated he could see a tapering in support by the end of the year, but the market largely ignored that. However, if we hear that elsewhere, beware as the low rates forever theme is likely to be questioned, and the dollar could well find a lot more support. The thing is, I don’t see that at all, as ultimately, the Fed will do all they can to prevent higher yields. For now, the dollar has further room to climb, but over time, I do believe it will reverse and follow real yields lower.
Good luck and stay safe