The US dollar’s ‘smile’ looks painted on
Only a return of more aggressive US Federal Reserve (Fed) easing speculation or a switch out of relatively expensive US stocks seems likely to wipe the US dollar’s smile off its face.
Currency markets still appear to be in thrall to the so-called “US dollar smile” – the model that posits two extreme scenarios which both tend to boost the US dollar.
The theory is essentially this: the US dollar rises in good times (relatively strong US growth, “risk-on” markets and high asset returns) and in bad (times of global risk aversion that draw domestic capital home to cash and overseas money to the safety of US Treasuries), but sags in between.
Those “in between” times are often when US interest rates are low or falling, and the domestic economy is muddling along or under-performing relative to its global peers.
Right now, the US dollar is being underpinned to varying degrees by both sides of that smile: market turmoil in China, recession in Japan and Britain, and geopolitical tensions around the globe on one; a stubborn Fed that is in no rush to ease policy ahead of other central banks, and a booming tech-led Wall Street on the other.
long-forecast US dollar declines seem exaggerated and short positioning increasingly under water.
What’s more, currency markets are quite relaxed about it – as the US dollar climbed to a three-month high against a basket of major rivals this week, implied volatility across major currencies has slid to a two-year low.
So far this year Wall Street is up, Treasury yields are holding firm, and the US dollar is proving hard to unseat. Two factors could push the US dollar higher still in the near term – investor positioning and rate differentials.
A wobbly Us$8.4bil bet
While many of the big investment banks, such as JP Morgan, HSBC and Deutsche Bank, are recommending their clients buy US dollars over other currencies, the speculative trading community has yet to fully get on board.
The latest Commodity Futures Trading Commission figures show that hedge funds are still net short of US dollars – essentially sellers of the currency – against a range of Group of 10 and key emerging currencies.
Granted, that position has been cut to under Us$1bil, the smallest in almost three months. But there is plenty of scope for funds to start going “long”, especially against the euro.
Funds have cut their net long euro position to the smallest since October of 2022, but they are still effectively holding a Us$8.4bil bet that the single currency will strengthen.
That’s a bold call when relative US and eurozone rate expectations are shifting further in the US dollar’s favour – rates markets are now pricing in around 120 basis points of policy easing from the European Central Bank this year and 100 basis points from the Fed.
“The strong US dollar story is not over yet, with the likelihood that the Fed lowers its policy rate gradually, US yields stay relatively high and global growth remains slow,” according to Paul Mackel, global head of forex research at HSBC.
Euro parity?
Only a few weeks ago, rates markets were pricing in 160 basis points of Fed rate cuts this year starting in March. That equation is now looking like 100 basis points of cuts starting in June.
The US dollar has appeared more sensitive to US rates and yields recently than equities, tending to rise and fall with bond yields irrespective of the corresponding moves in stocks.
Whether traders think the Fed’s rate-cutting cycle will be shallower than expected for “good” reasons – a growth-driven “soft” or “no-landing” scenario that juices equity prices – or because inflation is uncomfortably hot, the result is the same – a stronger US dollar.
Deutsche Bank’s Alan Ruskin reckons the US dollar’s sensitivity to the Fed’s first move is such that if the US central bank doesn’t cut rates in May, the euro will fall towards US$1.05.
His counterparts at JP Morgan agree, and even float the possibility that the euro tests one-to-one parity with the US dollar in the coming months if the eurozone’s economic downturn deepens.
“The 2024 Fed rate cuts will come amid the most synchronised global easing cycle in recent history, leaving US yield spreads elevated.
The Fed’s dovish pivot by itself is thus not enough to be bearish (on the US dollar),” they wrote on Tuesday. — Reuters