The dollar’s slump, despite a raft of positive news that should be the springboard for a strong start to the year, is puzzling. But puzzled or not, hedge funds are sticking to their guns, betting that the greenback will soon bounce back.
Pulling back the lens a little, the dollar was on the skids before the turn of the year. It has now weakened four weeks in a row for the first time since July 2020 and only the second time in three years.
In a mirror image of last year, when it defied the overwhelming consensus that it would weaken, the dollar is going against the current consensus that is should strengthen.
Hedge funds, at least, seem to be holding their nerve. The latest Commodity Futures Trading Commission data for the week ending Jan. 11 show that speculators held a net long dollar position against a wide range of major and emerging market currencies worth almost $20 billion.
That is little changed over the past six weeks. Indeed, as the following chart shows, funds’ conviction over the past three months that the dollar will strengthen has been strong and steady.
Its continued decline in the face of a dramatic ratcheting up of U.S. interest rate expectations, with Fed officials right across the ‘dove-hawk’ spectrum now advocating tighter policy, is particularly surprising.
Money markets are pricing in almost 100 basis points of rate increases this year starting in March, and most big banks on Wall Street have revised their outlooks along these lines. JP Morgan Chief Executive Jamie Dimon thinks there could even be six or seven hikes this year.
U.S. bond yields have surged, and CFTC funds have opened up their biggest net short 10-year Treasury position in two years. The sell-off at the short end has pushed the two-year U.S. and German yield spread out to over 150 basis points, the widest gap in favor of the dollar in the pandemic era.
As analysts at Bank of America note, the last few weeks could not have been more dollar-friendly: U.S. inflation at a 40-year high of 7%, consistently hawkish Fed-speak pointing to a March liftoff and ‘quantitative tightening’ this year, U.S. rates selling off, and equities correcting lower.
But the dollar is not playing ball.
It just had its biggest weekly fall against the yen (-1.2%) since November 2020 and sterling is on its strongest weekly run since May. Against a basket of major currencies, the dollar is down 0.8% this year.
What gives? Perhaps the market is looking beyond the Fed’s rate hike path for signs that other central banks will soon start tightening policy.
Until last week, even the suggestion that the European Central Bank could start raising rates this year was fanciful. But more than 10 basis points of tightening is now being priced in, and even the Bank of Japan is debating how soon it can start telegraphing an eventual interest rate hike.
“As long as interest rate differentials do not move materially much further in the dollar’s favor, it will become difficult for the dollar to extend its rally, now that yields outside the US are also progressively moving up, both in Germany and in Japan,” wrote Unicredit’s FX team on Friday.
For the dollar to turn around quickly, as hedge funds and most analysts expect, the Fed may have to send an even more aggressive signal from its Jan. 25-26 policy meeting.
The dollar often strengthens ahead of the start of a Fed tightening cycle then eases off once it gets underway. While the Fed won’t change policy later this month, it will likely clear the runway for liftoff in March, and give further detail on when and how it will start reducing its balance sheet.
Having steered the market to lean toward four rate hikes and ‘quantitative tightening’ this year, the onus may be on the Fed to back up rhetoric with action.
As former Fed Vice Chair Alan Blinder commented last week on Fed communication more broadly: “Generating trust and credibility is absolutely critical, top of the pile for central banks. You do that by doing what you said you will do.”
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