Currency Update: Changes in Narrative

My longer-term currency views tend to be dominated by two factors: where we are in the global risk cycle and where the ECB and the Fed are in their tightening/loosening cycles relative to each other.

For me, the dominant long-term view today is investors are moving out the risk spectrum because US valuations seem full. This phase of the global risk cycle tends to be bearish the dollar as flows go from core to periphery in search of yield and more attractive valuations.

Pushing in the same direction is the relative cycles of the world’s two most important central banks. The US has raised rates a number of times and is about to do it again next month. It has also started to let its balance sheet run off. It is closer to the end of its hiking cycle than the beginning.

The ECB, in large part due to Europe’s poor and begrudging policy response, is several steps behind in the normalization process. They are very much at the beginning.

This too tends to be bearish the big dollar.

However, these processes are not straight lines. Up until September, the market had been skeptical of the Fed’s willingness and ability to normalize policy along the lines of its forecast. After all, the Fed has systematically over-forecast the pace of policy normalization for years. And as a result of this skepticism, the dollar, correspondingly, remained under pressure. But in September, when it became clear the tapering was going to happen as projected, this all changed, taking the attention away from the ECB’s normalization process and putting it back on the Fed’s. The market, basically, had to play catch up. From then until now, the two-year Treasury yield soared by nearly 50bps, and the odds of a December rate hike went from around 20 percent to 92. And, of course, this triggered a fairly strong counter-trend move in the dollar—one that, admittedly, chopped my currency trading up pretty well in September and October.

Here’s the time series of December rate hike odds:

But the bottom line here is that it looks like the counter-trend dollar rally is now over, and the downward trend is resuming. There are three reasons why I think the narrative of normalization is in the process of shifting back to the ECB. One, Chair Yellen last week expressed more concern than ever before that the stubbornly low US inflation may have a structural component. What’s more, this sentiment was echoed in the Fed Minutes also released last week. Two, the ECB’s Benoît Cœuré dropped a surprisingly heavy hint (one of, I suspect, several to follow) that they may have to move forward the beginning of policy normalization. And he says this against a backdrop of an ECB running out of FI assets to buy and European PMI that are moving from strength to strength. And three, the move in short term US rates and in rate hike expectations have been sharp and have lost momentum, and many currency charts are once again showing dollar weakness.

Here’s the 5 year chart of the BBDXY:

And the 1 and 5 years charts of the euro:

Now, here’s the 5 year chart of El Perro:

And,  the 5 year chart of the Brazilian real:

I have spent the last 3 weeks vacillating between signs on the one hand that the dollar is starting to roll over, and signs on the other that precious metals are on the verge of a big break down—two somewhat contradicting views. But now, at least to my eye, it looks like we have a decision in favor of a weaker dollar.

That said, it is conceivable though not likely, that we get a weakening dollar and weakening precious metals, since the crux of the narrative is that we’re now entering the European leg of global monetary tightening. At a minimum, precious metals should be an excellent funding leg for short dollar positions.

EUR in gold terms looks to be breaking out:

All these charts look to me like a new leg of dollar weakness is upon us. And it seems lined up nicely with the monetary policy normalization narrative shifting back to the ECB.

Good luck, and don’t forget to manage your risk—no matter how strong your conviction.

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