There are tens of thousands of financial instruments investors can trade to gain access to hundreds of markets across all four major asset classes: stocks, bonds, currencies and commodities. Of the plethora of instruments and markets to be traded, there is one that causes more ripples across the globe than all the others, the US Dollar.
Despite being pronounced dead on many occasions in the past and despite the cryptocurrency fanatic’s best efforts to convince you otherwise, it’s still all about the benjamins. The dollar remains King and is currently at a critical inflection point, which will have widespread market ramifications.
The Path Taken
The US Dollar has started the year pretty much in a straight line down to a 9% loss. You’ll find any number of reasons why the USD has looked as ugly as homemade sin but there has been one primary downside catalyst for the world’s reserve currency, policy convergence.
I wrote many times throughout 2014 and 2015, about the “US Policy Divergence” theme. This divergence developed when the Fed began its normalization path while the rest of the world’s central banks, namely the ECB and the BOJ, were keeping their “monetary easing” pedal to the metal.
The primary beneficiary of this policy divergence was the USD, which saw massive inflows and moved from a June 2014 low of $78.80, to breaking the century mark at $100.33 by mid-March 2015.
However, since mid-2015, this policy divergence has been shifting, primarily due to the modification of ECB policy. When the ECB began buying assets, it was buying $80B a month. Last year, they adjusted course, reducing the monthly purchases to $60B, which at the margin, is tighter monetary policy.
The USD responded to this policy convergence by trading sideways for well over a year before making one last push higher at the end of last year. Since peaking in late December at $103.00, a 15-year high, the greenback has declined 11%, and is now sitting at $92.85.
Part of the decline of the USD Index (DXY) can be attributed to the overwhelming strength in the euro because DXY is a basket of currencies, of which the euro represents 60%.
Investors have been piling into the euro at a record pace believing the ECB has all the economic evidence it needs to have its very own taper announcement. Those investors are now eye guzzling the September 7 ECB meeting as the most likely time and place for such an announcement.
The Catalysts for Inflection
I haven’t bought into this “taper” belief and the recent rollover in inflation readings is bolstering my confidence that investors are about to be caught wrong footed.
The core CPI readings for August came in a 1.2%, which is both well below the ECB’s 2% mandate and at the top end of its 5-year trading range between +0.6% and 1.2%. Not only that but inflation has slowed in four of the last six months. Trend anyone?
But it’s not just about weak inflation. Last week, Reuters reported that “sources” familiar with ECB discussions revealed that the euro’s strength is “worrying a growing number of ECB policy makers,” which “increases the chance of a delay in their QE decision, or a more gradual exit from asset purchases.” The sources went on to say the ECB “could further relax a requirement to buy bonds in proportion to each country's ECB shareholding, or include new asset classes such as stocks, as raised in July by one policymaker but not given consideration, or non-performing bank loans.”
As my boy Emeril says, “Bam!”
Even before these statements, I didn’t understand where euro bulls got their conviction. From where I’m sitting, Draghi is going to have to do one hell of a line dance to deal with the effects of a strong euro coupled with inflation that is in a solid downtrend.
Bottom line is Eurozone inflation isn’t breaking out to the upside anytime soon and if the ECB is now setting its sights on weakening a euro that is stronger than they like, watch out. This not good news for the uber-crowded trades in the euro or being short the greenback.
More Shorts Than Lake Havasu
To say positioning in the USD has gotten a bit “tilty” this year is an understatement.
The weak USD has been a catalyst for several trades that investors have plowed money into this year, primarily: the emerging market equity rally, fixed income rally (in conjunction with weaker inflation expectations) and finally, it’s been a critical component in the US equity rally. The S&P 500 is currently rocking a -0.88% correlation to the USD, that’s one hell of a strong relationship and it means that when the USD rallies, the S&P 500 heads south of the border.
Investors have more short exposure in US dollar futures than at any time in the last three years. On the flipside, bulls have retreated and hold the lowest number of long positions, when compared to the 3-year average number of long contracts, in 20 years! This extreme positioning, on both sides of the trade, has led to the shortest net positioning in greenback futures in quite some time.
Beyond the actual USD contract, the world hasn’t been this short of US dollars, via long positioning in other currencies, since the end of 2012. It’s worth noting the USD gained 5% in the first seven months of 2013 following this extreme “tilty” positioning when everyone was hovering on one side of the boat.
These folks are providing the very kerosene that will ignite the dollar’s move higher once the short squeeze begins.
The Bottom Line
Remember, what matters most in economies and financial markets is what happens at the margin. If there is a “lessening” in the policy convergence between the ECB and the Fed, this could quickly turn into a powder keg situation given the extreme, and broad-based, USD bearishness right now.
If the USD closes above $97.73 for three consecutive days, that’s when the fun begins. If you’re in one of the popular kid trades I mentioned then keep your head on a swivel. And as always, stay data-dependent, process driven and risk conscious my friends.