April 04

Stage Set For US Dollar Rally

2014 began with a wide market consensus that the US Dollar would begin a multi year rise driven by a normalization of Federal Reserve monetary policy. So far this move has not materialized as a harsh winter stalled economic momentum. Extraneous factors have also weighed on the Dollar in Q1 2014. A portion of the US Dollars purchased by the Peoples Bank of China during their February FX intervention  have no doubt been diversified into EUR and GBP(USD selling). Verizon’s buyback of half its stock from the UK firm Vodafone also required massive USD selling to the tune of $130bn.

All three of these factors will subside in the second quarter of 2014, setting the stage for a significant move higher in the greenback. As of the last commitment of traders report, leveraged speculators were actually positioned short the US dollar for the first time since late December 2013. The trading style of these types of speculators is momentum driven. The recent sharp reversals in the Australian and Canadian dollar have flushed out many trades that were bet long the US Dollar versus those respective counterparts. Meanwhile a stubbornly strong EUR and GBP have attracted speculative flows due to their consistent rise over the past few months. Dollar/Yen was bouncing around inside a range between 101 and 103 and speculators struggled to get a foothold with long Dollar bets. On balance, US dollar positioning has not increased very much in either direction this year.

The main focus here is that the market is not positioned for a US dollar rally, and is actually currently positioned long the EUR. Since January the favored currencies to express US Dollars longs against(AUD,CAD,JPY and EM) have all since flushed out most positions. Aside from the Yen, it is expensive to hold shorts against many of these higher yielding currencies. Investors have reduced positioning, trading volumes have fallen and FX implied volatility for most major pairs has declined to lows not seen since 2008.

The April 4th jobs report may be the spark to force markets to re-calibrate the risk for when the first Federal Reserve rate hike will occur. Futures currently price in the first 25bps rate increase for April 2015.  With each piece of strong economic data the schedule for rate hikes will be pulled closed to the present date, this movement also pushes up short term US treasury yields.

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If you look at 2 year US bond yields it is becoming clear that the short end of the yield curve will be under significant upside pressure if there is a surprise tomorrow. Breaking above 0.50% would be a milestone, marking a level not seen in several years. The two year yield is a cornerstone driver of FX rates, and with Eurozone rates likely frozen in place by Draghi’s QE threats the US Dollar could see significant gains specifically versus EUR and CHF.

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