Back on 22nd April, we said that we thought the US Dollar was on the cusp of an important move, and that it was time to sit up and pay attention. Since that time, the Dollar has risen by the best part of 5% in just over two months, not a bad move in FX markets. We now think that this move is getting a little tired and we would not be surprised if the Dollar experienced a period of softness ahead. Given the weakness in emerging market assets as the recent Dollar rally progressed, we think that risk assets generally will enjoy a period of Dollar weakness. What we are not entirely certain about is how big a correction the Dollar may endure here (if any at all) and therefore how big a bounce to expect in risk assets.
Chart 1 below plots the US Dollar index on a daily basis. What we see here is that from late April and through May, price advanced steadily with only shallow corrections. Since the end of May, price is basically flat and price action is much more choppy. The recent highs in the last week or two were not confirmed by momentum (green histogram) and stochastics (lower panel) are beginning to roll over. This type of price action is indicative of a period of consolidation ahead, in our opinion.
Chart 1 – Daily US Dollar chart with 21 day moving average
If we step back and look at the weekly chart, there is some resistance in the 95+ area that has so far held the recent advance. As we said above, we are not sure exactly what path any consolidation may take for the Dollar, if one were to occur, but our working roadmap is that this is just a consolidation in a larger uptrend. Perhaps a consolidation will be orderly and find support in the 92 area, before the Dollar bull market resumes. Of course, a lot will depend on what path the major central banks will take in the meantime.
On this point, we expect the Fed to maintain the current trajectory of gradual rate rises (we’ll go with two more this year) and quantitative tightening, which increases from $30 billion per month in Q2 to $40 billion in Q3 and $50 billion in Q4. Every other central bank wants to be more dovish than the Fed, and nobody wants a strong currency. Perversely, nobody wants the Dollar to be too strong either (including president Trump), and so policy makers face a bit of a dilemma at the moment, given the cracks emerging in some corners of the global markets after only a modest move in the Dollar.
Chart 2 – Weekly US Dollar index with 21 week moving average
When we look at positioning of the speculative crowd, we see that they have finally jumped on the bullish Dollar story. With markets seemingly trying to hurt the most people most of the time, will this recent surge into Dollars prove to be a tactical error, or is this just the start of a larger trend of Dollar buying? As we have noted, our roadmap for the Dollar is consolidation followed by further advance, so for long term players, we think it’s buy the dip for now.
In terms of crowded trades, despite US yields moving lower and signs of global wobbles, speculative accounts have barely reduced their record short position in the 5 and 10 year part of the curve. So, as we sit here thinking about what would cause the Dollar to soften a little in the short term, we don’t think it will be global central banks suddenly becoming more hawkish than the Fed. It is more likely that either the Fed backtracks a bit, Trump verbally intervenes or economic data soften a bit. If any of these things happen, we think that US yields could move a bit lower as speculative accounts close out their short positions.
So, how do we play this upcoming Dollar consolidation in the markets? Well, we will stick with our larger multi-month topping process for now. If we are right about both the US Dollar softening and US yields drifting lower, then we think equities can rally a bit. But, we still think it’s a matter of selling rallies rather buying dips in this asset class. We will hold our high quality US bonds for now, and although we would expect credit spreads to tighten a little bit, we are just not that interested in owning these assets longer term as the spread is just too tight from an historical perspective, especially given the maturity of the economic cycle.
We would be cautious about actually selling the Dollar here other than for a very tactical trade. In fact, it would need a complete reversal from the Fed to a dovish path for us to think about selling the Dollar longer term.
So, the message this week is that we may see a reversal of the trend apparent in some markets in recent weeks, but we don’t think this is necessarily a strong reversal; more of a consolidation. There are times in markets when it is right to press your trade ideas and times when doing nothing is the right thing to do. Boring as this may seem, we think that we may be moving into a summer lull in markets. When we discussed this potential internally last week, there was definitely some push back. Given the ephemeral nature of liquidity in markets today, it is certainly possible that something happens in the weeks ahead to shatter the calm in markets that we think we see coming, and price volatility could pick up quite substantially. As such, we all need to remain alert, especially if our multi-month topping process is correct.
So, to wrap up this week, we have been of the view that the Dollar has been taking the role of the pied piper in recent weeks, and therefore a consolidation for the Dollar should help risk assets. But we are not advocating a big shift to risk on at all. Any rally in risk assets should prove relatively muted and should be used to raise defensive positions for those that have not yet done so and are worried about a potential multi-month top in markets.