Currencies are about stories more than any other asset class. There are no P/Es. There is no tangible book value. Concepts like PPP and unit labor cost differentials only exert their gravitational force over the very longest of terms, especially in today’s world of capital account primacy.
The stories don’t have to be true. They don’t have to be grounded in good fundamental analysis. All they need is to be intuitively compelling to a large part of the investor base and consistent with concurrent price action. And, if the price action also happens to run against the grain of heavy positioning, then one has the makings of a powerful trade.
Right now, the odds are good that we are about to have that kind of convergence of story, price action, and positioning in bonds and the big dollar, in particular against the funding currencies.
Patterns
First, the patterns suggest the dollar is on the verge of busting a move higher.
Here’s the one-year chart of the broad USD index that I prefer to track (BBDXY):
Now look at the yen:
The Canadian dollar is not exactly a funding currency, but the one-year chart of USDCAD looks very bid:
Now have a look at precious metals. GDXJ is the best example, in my opinion. And usually precious metal stocks lead the metals themselves. GDXJ appears to be breaking down. Here’s the one-year chart:
GDX, for what it’s worth, is similarly vulnerable.
Then there’s platinum, which most of you who follow my tweets know I often use as a “tell” for precious metals. Platinum has been flirting with 900 for the last two years and continues to underperform the other precious metals. You can see this best on the 5-year chart:
Now, let’s have a look at bonds. Here I use the 10-year note on a one-year chart:
It probably looks worse on a 5-year chart:
Positioning
The bottom line here is that bonds and bond proxies are overbought and investors are structurally short dollars. In addition, a lot of hedge funds have flatteners on. Something like long 30s, short 5s. And precious metals have very few shorts.
Here is a proxy for positioning in the euro over the past 10 years, from the weekly CFTC numbers:
It’s very high.
Here are net platinum positions for small spec over the past 10 years:
And now here are small spec gold shorts:
Low and turning up.
Here’s the CFTC positioning on the 10-year note:
It’s very high and rolling over.
Now, with respect to the flattener. Have a look at the UST 5-year futures and the UST long bond futures:
The divergence is pretty stark. Now, many of the shorts in the 5-year futures reflect mortgage bond hedges, but, still, a lot of people have flatteners on. And this flattener has massive negative carry. More on this below.
Narrative
So, what’s the story and why now? First, tax cuts and repatriation. It doesn’t matter at this point whether it happens or whether it would have the desired effect. The point is right now tax cuts have momentum, and the odds of something passing are going to grow in the near term, not shrink—irrespective of whether something ultimately passes.
The standard macro playbook (again, doesn’t matter if you and I think it’s right) says repatriation will give a bid to the dollar and stimulus will lead to higher UST yields, especially at the long end due to increased supply from larger deficits (plus, in this case, the Taper). Some may even speculate that a tax bill will lead to a more hawkish Fed, even though I don’t think it is that simple. So, in short, it’s easy to slap this narrative onto concurrent price action of a stronger dollar and a higher and steeper yield curve.
It is important to underscore that 6 months from now that this story could have already fallen apart and the relentless structural bid in the long end of the Treasury curve will have already reasserted itself. But I think for now the story meets the criterion of “intuitively compelling”.
That the Trump administration is about to name the next Fed chair and vice chair only adds to the story. Here there are two observations to make. One, most investors have felt for a long time that “policy rates are just too low”, and that a dovish Fed has impeded proper normalization. Virtually all of the candidates (with the possible exception of Powell) think—based on the same set of data—that the Fed should have started to normalize earlier. They also, like many investors, have anchored on a higher terminal rate than the Fed’s current leadership. And this, despite Trump’s offhand comments about being “a low rates guy”, is something investors are likely to keep in mind.
The second point is behavioral. Often when there is an “event”, like naming a new Fed chair, it forces markets to reappraise their views and positioning. In efficient markets, this should be discounted in advance. And sometimes it partially is. But, over my career, far too often somewhat random and sometimes disconnected events have this catalytic effect. Naming new leadership against the above backdrop is the kind of thing that could trigger it.
Within the currency space, I would expect the funding currencies to come under more pressure than the risk currencies, but this will depend a lot on what stocks do. If the bond move (should it materialize) be orderly and incremental, then risk assets could well do fine and risk currencies would outperform. I really think it’ll come down to the speed of a bond unwind.
And, needless to say, it might actually be a good tactical moment for bond vol, the trade that seems to be on the lips of everyone in the macro community. I personally would prefer to put on a 5s30s steepener to play this dynamic. The positioning is favorable, and it carries positively to the tune of about 5.5% annualized. Much better than bleeding theta by being long vol. (It is also not clear to me, despite all the scary charts we’ve seen on Twitter, and all the talk of the Target manager who sells vol, that the positioning is as attractive in vol space, given how many gorillas are long it.)
In short, I think the odds are good that positioning, patterns, and plausible story have converged for a directional push in currencies and bonds. And my preferred way to play it would be through shorting the funding currencies and precious metals, and through paying a steepener in 5s30s. But, as we all know, it is very easy to be wrong about these things, so don’t lose sight of your risk management.
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