Currency market’s bet against the US dollar is getting riskier by the day
Neal Kimberley warns that the currency market’s aggregate short position on the US dollar is looking vulnerable, with the euro zone performing worse than expected and the latest US data reflecting economic health
There are almost 24 billion reasons why the US dollar could strengthen. Away from the weak Hong Kong dollar narrative, there is an even bigger story, one where the foreign exchange market has made a massive structural bet against the US dollar that looks increasingly stale and vulnerable.
Data for the week ending April 24, released on Friday by the US’ Commodity Futures Trading Commission (CFTC), may have indicated, as Canada’s Scotiabank noted, “a sizeable reduction in the [International Monetary Market’s] aggregate bearish bet” on the greenback, but the Canadian bank nevertheless still quantified the remaining aggregate US dollar short position at US$23.9 billion.
By definition, such a trade is predicated on individual market participants’ views that mass investor opinion will judge that circumstances favour other currencies over the greenback. But circumstances change.
The currency market should think twice about the sustainability of this short US dollar position. It is becoming increasingly clear that the allure of alternative currencies, such as the euro in which much of the CFTC’s aggregate short US dollar position is concentrated, is fading even as reasons to justify US dollar strength re-emerge.
Last Thursday’s European Central Bank (ECB) policy meeting left monetary policy settings unchanged, acknowledging that the pace of euro zone economic growth had moderated since the start of 2018 and that “measures of underlying inflation remain subdued”.
Against that background, it’s hard to imagine that the ECB would favour the euro, which was trading at 1.21 versus the US dollar at the end of last week, appreciating further.
Indeed, “if the recent [euro zone] data weakness turns out to be more protracted”, Stephen Li Jen of London-based Eurizon SLJ Macro wrote on Thursday, “we should expect the ECB to react by postponing the timetable they have forward guided. EURUSD could trade back down to 1.15 or so.”
That would entail a world of pain for those stuck in a long euro/short US dollar position.
Elsewhere in Europe, the Swiss National Bank still views the franc as highly valued and, as the bank’s chief Thomas Jordan reiterated on Friday, will continue to pursue its ultra-accommodative monetary policy and remains willing to intervene in the foreign exchange market if necessary.
As for the British pound, as speculators discovered to their cost last week when Britain’s first-quarter gross domestic product data underwhelmed, betting on sterling’s strength remains a risky business. The old London currency market adage, that sterling goes up via the staircase but down by the lift-shaft, still holds.
Meanwhile, over in Asia, there’s arguably not a lot currently going for the Japanese yen.
With the Bank of Japan still sticking to its own ultra-accommodative monetary policies, and with higher US yields available, a number of Japan’s life insurers are now contemplating boosting their exposure to US dollar-denominated bonds on an unhedged currency basis, a process that would lend itself to yen weakness, not strength.
As for China, where a cut in the reserve requirement ratio became effective on April 25, it might be perfectly logical for the People’s Bank of China to stick to neutral-to-looser monetary policy settings when structural economic reform is in the offing, even if the US central bank continues to raise interest rates.
And no one should be under any misapprehension about that latter prospect.
While it shouldn’t happen when the US Federal Reserve announces its latest monetary policy decision on Wednesday, the market is assuming another US rate rise in June.
Data on Friday showed US GDP expanded by 2.3 per cent on an annualised basis in the first quarter of 2018, below the 2.9 per cent growth of the last quarter of 2017, but healthily above the 2 per cent rise that economists polled by Reuters had forecast. Additionally, the US Labour Department said wages and salaries rose by 0.9 per cent in the first three months of the year, the largest jump since the first quarter of 2007.
The Fed will also have noted that Monday's release of its own preferred measurement of inflation, the core personal consumption expenditures index, showed a 1.9 per cent jump in March year on year, up from February's 1.6 per cent rise.
The harsh reality is that the costs of shorting the greenback seem set to rise further, even as the arguments for doing so appear less compelling.
With the attractiveness of other currencies arguably lessening and US monetary policy set to tighten further, the currency market feels short and caught with its aggregate bet against the US dollar. The foreign exchange market may have to buy US dollars, whether it likes it or not.
Neal Kimberley is a commentator on macroeconomics and financial markets