ORLANDO, Fla. Jan 17, Reuters - The dollar is in a slump despite a raft of positive news that should be the springboard for a strong start to the year. But puzzled or not, hedge funds are sticking to their guns, betting that the dollar will bounce back soon.
The dollar was on the skids before the turn of the year, pulling back the lens a bit. It has weakened four weeks in a row for the first time since July 2020 and only the second time in three years.
In a mirror image of last year, when it defied the overwhelming consensus that it would weaken, the dollar is going against the current consensus that it should strengthen.
Hedge funds, at least, seem to be holding their nerve. The data released by the Commodity Futures Trading Commission shows that speculators held a net long dollar position against a wide range of major and emerging market currencies worth more than $20 billion.
That has changed little over the past six weeks. The conviction of funds over the past three months that the dollar will strengthen has been strong and steady, as shown by the following chart.
Its decline in the face of a dramatic ratcheting up of U.S. interest rate expectations, with Fed officials right across the 'dove-hawk' spectrum now advocating tighter policy, is particularly surprising.
Money markets are pricing in over 100 basis points of rate increases this year starting in March, and most big banks on Wall Street have revised their outlooks along these lines. JP Morgan Chief Executive Jamie Dimon thinks there could be six or seven hikes this year.
U.S. bond yields have gone up, and CFTC funds have opened their biggest net short 10 year Treasury position in two years. The sell-off at the short end has pushed the two-year U.S. and German yield to over 150 basis points, the widest gap in favor of the dollar in the pandemic era.
The last few weeks could not have been more dollar-friendly: US inflation at a 40 year high of 7%, hawkish Fed-speak pointing to a March liftoff and a quantitative tightening this year, U.S. rates selling off, and equities correcting lower, according to analysts at the Bank of America.
The dollar is not playing ball.
It just had its biggest weekly fall against the yen since November 2020, and sterling is on its strongest weekly run since May. The dollar is down 0.8% this year against a basket of major currencies.
What's the best thing that comes with it? Perhaps the market is looking beyond the Fed's rate hike path for signs that other central banks will start tightening policy.
It was fanciful to think that the European Central Bank could start raising rates this year. More than 10 basis points of tightening are now being priced in, and even the Bank of Japan is debating how soon it can start telegraphing an eventual interest rate hike.
Since interest rate differentials do not move much further in the dollar's favor, it will be difficult for the dollar to extend its rally, now that yields outside the US are progressively moving up, both in Germany and Japan, according to Unicredit's FX team on Friday.
As hedge funds and analysts expect, the Fed may have to send more aggressive signals from its Jan. 25 -- 26 policy meeting to the dollar to turn around quickly.
The dollar can strengthen ahead of the start of a Fed tightening cycle, then relaxes off once it gets underway. While the Fed won't change policy later this month, it will likely clear the runway for liftoff in March, and give further details on when and how it will start reducing its balance sheet.
The Fed may back up rhetoric with action after steered the market to lean toward four rate hikes and quantitative tightening this year.
As former Fed Vice Chair Alan Blinder commented last week on Fed communication more broadly, trust and credibility is a top priority for central banks.