The year of the dollar bull

It has been a long time coming. Markets have been watching the dollar closely, wondering when it would awaken. In August – ironically, a time of year when the markets are usually at their quietest – it finally happened.

“Everyone [in 2014] was waiting for the euro to fall and the dollar to rise against most currencies,” says Mohammed Grimeh, regional head of financial markets for the Americas at Standard Chartered.

“The Fed had been preparing the market for the end of quantitative easing (QE) and monetary tightening for a long time, while the European Central Bank (ECB) and Bank of Japan (BoJ) were expected to ease and stimulate their economies. There was no real surprise in 2014 among the G10 currencies, but the market has had to wait a long time.”

While technically the market is still waiting, with US rates unchanged and the ECB still dithering about QE, August marks the point at which the market reacted to the anticipation, if not the events. The watershed was transformational for FX, triggering a US dollar rise that is now being described as a dollar bull market – rather than merely a correction. Now everyone is excited about a lively 2015.

Andreas König, head of FX Europe at Pioneer Investments, says: “The FX asset class is completely different depending on whether the dollar is in a bull or bear market. In a dollar bull market, everything is driven by the dollar; smaller currencies in particular become much less important. The world becomes more black and white, depending on your view on the dollar.”

Although the return of volatility has FX traders rubbing their hands with anticipation, there is a downside, spelling, as it does, the end of cheap dollar-denominated funding. Along with Chinese growth, this has done much to turbo-charge global growth in recent years.

David Woo, head of global rates and currencies research at Bank of America Merrill Lynch (BAML), predicts a challenging year. “The obvious trades such as the long US dollar trade are already crowded,” he says. “There also may be more volatility than trends, which means making money could require more frequent tactical manoeuvres.”

The trick

The trick will be finding other trading opportunities at a time when most central banks are looking to weaken their currencies, and timing the market. The UK election has traders particularly flummoxed.

Steven Englander, global head of G10 FX strategy at Citi, says: “Investors don’t see any positive outcomes for GBP, with a Labour majority/coalition bad for business and Conservative majority/coalition raising prospects of Brexit.”

For most currencies besides the dollar, it looks like a race to the bottom. The Canadian dollar will be squeezed by its rate differential with the US, cheaper oil and poor competitiveness, while the Aussie is also hurt by weak commodity markets undermining its terms of trade with China.

Yet some will have to rise against each other. “Notwithstanding the ECB’s heroic efforts to talk down the EUR, the eurozone trades with a lot of countries whose exchange rates are as weak as, or weaker than, the EUR, so there is more work to be done to avoid the zero inflation threshold,” says Englander.

However, overall euro weakening has much further to go, says Englander, adding: “We see EUR as a third-to-a-half of the way through a long-term weakening cycle and that stabilization of the currency isn’t likely until sometime after 2016. The key theme for 2015 is to avoid getting flattened by an occasional correction.”

A more difficult call will be how the other big currencies trade against each other, ignoring the dollar. Everyone agrees euros and yen are set to slide against the dollar, but how will they fare against each other?

Standard Chartered’s Grimeh says: “EUR/JPY is a tough call, but if I was pressed I would go long euros against yen, simply because the BoJ is ahead in its QE programme including quantum, and its recent election outcome has confirmed broad support for its current policies.

“In Europe you have Germany and most of northern Europe that could resist or put the breaks on any full pledge for QE and currency depreciation. On the other hand, consensus appears to point to downside in euro. 1.12 EUR/USD is priced as more likely than 130 USD/JPY”

However, as one of the few real candidates for currency strength, the real upward pressure is on the dollar.

Pioneer’s König says: “If every currency wants to weaken, they need something to appreciate against and only the dollar looks capable of absorbing that level of strength. The question is how long it can last. If inflation or growth dip in the US, things can change pretty fast, but until that happens I expect the trend to continue.”

Says Woo at BAML: “In 2014, investors found that the right trade, when it is crowded, often becomes the wrong trade. In other words, it sometimes pays to take the other side when positioning becomes too one-way.” USD/JPY, for example, looks vulnerable to a pull back after its recent surge, he says.

However, while everyone agrees it will be a bumpy ride for the dollar, few question the overall long-term direction of the market.

Grimeh says: “Dollar appreciation is based on the differential between implied interest rates and growth in the US versus other countries – to reverse you would need higher rates from the ECB and lower rates from the Fed.

“That isn't going to happen in the next few years. So while it won’t come in a straight line and there will be consolidation along the way, the dollar is going to trend up for years. In addition to growth differentials, this is a consequence of the divergence between the two central banks.”

'Malign not benevolent'

HSBC worries that “if USD strength were to become extreme, the results could become malign rather than benevolent”, citing the risk that currency wars spiral out of control leading to currencies collapsing, the falling euro could reignite break-up fears and there is the possibility of an emerging-markets crisis.

The answer would be for the leading players to “co-operate on currency policy”, says HSBC, though it concedes that outcome is unlikely. “We need an accord to stop a crisis, but can only get an accord if there is a crisis,” states HSBC. “This is a catch-22 situation that suggests the risks are for an even stronger USD than the market currently envisages.”

A long-established truism in markets is that when everyone agrees on the inevitability of a trend, the chances are there is a surprise in store.

“We are long USD along with everyone else, and that is reason enough to be cautious,” says Citi’s Englander. “In fact, the risk of a market correction between now and end-January is high enough that we would prefer to look over the next two months via options rather than go in via spot, unless there is new news to convince us that the USD rally will keep moving.”

König says: “The dollar looks expensive already if judged against its technical indicators, but the trend has further to go. There is a saying: a good trend never lets you in again.

“It is easy to underestimate the potential for dollar strengthening after so many years of range trading. After all, it has been around 15 years since the last real dollar bull market. Many participants in the market today have never even seen this before.”

Pioneer is long dollar and short euro and yen, but has small positions going into year-end.

“You need to manage the risk, especially in such a consensus trade,” says König. “If things change there will be a lot of people rushing for the door at the same time. Although we think it is a consensus trade and people are already positioned, the market trades as if investors would have a large position in their heads, but only a small position in their portfolios – so there is potential for more.”

Others might also be playing it safe and Englander says that investors are not overly long USD, with few investors fully catching the dollar’s recent rise.

“We consider positioning the biggest downside USD risk,” he says. “Long USD positions are not yet dangerously stretched, particularly versus JPY. However, we are concerned about the possibility that there will be a sharp episode of profit-taking as year-end approaches.”

Englander looks to 2005 for the precedent, when a similar dollar rally peaked in early December, before collapsing in January. “We think 2015 is the USD’s year, but are less convinced that the year will be made in January,” he says.

However, there are too many variables in 2015 to make high-conviction predictions about currency trends. Much will depend on the outcome of elections in Greece, Spain and the UK, the path of inflation and growth, the timing of Fed rate hikes, geopolitical developments, the price of oil and a host of other factors.

Whatever happens, it promises to be an exciting year for FX traders.