As far as “pain trades” go, this year’s dramatic decline in the US dollar ranks as one of the most excruciating.
Since the beginning of January, the dollar index - a gauge of the greenback’s performance against a basket of other currencies - has plunged 8.1 per cent to its lowest level since last September, with the bulk of the decline occurring in the last two months or so.
On Tuesday, the dollar was dragged down further by the failure of the US Congress to replace former president Barrack Obama’s healthcare system with a new scheme favoured by president Donald Trump and most of his Republican lawmakers.
The unwinding of “long dollar” positions began in the spring. According to the monthly Global Fund Manager Survey published by Bank of America Merrill Lynch (BAML), the dollar ceased to be the most crowded trade in April and has since been supplanted by the technology-heavy Nasdaq equity index and European stocks.
Trump’s political woes - the president’s authority and, more worryingly, America’s standing in the world have been severely undermined by the escalation of the Russia probe dogging the White House, with Trump’s approval rating now standing at just 36 per cent and nearly 50 per cent of voters believing his presidency has weakened America’s place on the world stage, according to a new Washington Post-ABC poll - are not the only factor weighing on the greenback.
Janet Yellen, the Fed chair, contributed to the weakness of the dollar last week by admitting that the recent decline in inflation may not be transitory after all and that “there could be more going on there”, fuelling speculation about a more dovish Fed.
The plunge in the greenback has been a boon for risk assets, particularly emerging markets. Since the start of this year, the Bloomberg JPMorgan Asia Dollar Index, which tracks the most actively traded currencies in Asia with the exception of the yen, has risen nearly 4 per cent.
The onshore yuan, moreover, has reached its highest level against the dollar in eight-months. Emerging market bonds denominated in local currency are all the rage, with foreign investors purchasing US$41 billion of Asian domestic debt in the first-half of this year, according to JPMorgan.
The euro has also benefited from the dollar’s tumble. Europe’s single currency has shot up nearly 9 per cent since mid-April to its highest level against the greenback since early 2015, increasing the appeal of euro-denominated assets.
Indeed, it has been mounting speculation in markets that the European Central Bank, which holds a closely watched interest rate-setting meeting on Thursday, is turning increasingly hawkish that has arguably been the most important factor behind the dollar’s decline. The yield advantage on 10-year Treasury bonds over their German equivalents, which according to Bloomberg was at its widest level since the 1980s in December as investors bet that the Fed would be forced to tighten policy aggressively, has narrowed 50 basis points since the start of this year, pummelling the greenback.
Yet the dollar could yet make a comeback later this year.
The jury is still out on how hawkish the European Central Bank is likely to be given subdued inflation in the eurozone and the fear on the part of Europe’s central bank that a premature withdrawal of monetary stimulus could provoke an even fiercer “tantrum” than the one triggered by the Fed in 2013.
A bond market crash has suddenly become the most important “tail risk” cited by fund managers, according to Bank of America’s survey published on Tuesday.
If the European Central Bank gets cold feet, the more hawkish stance of the Fed - which is the most advanced in tightening policy among the major central banks - will come back into focus.
Dollar bulls still have reasons not to despair.
Nicholas Spiro is a partner at Lauressa Advisory