The Dollar, the Euro and Rates

One of the strongest beliefs in currency markets is if a central bank is hiking policy rates its currency will strengthen. Nowhere is this a more powerful thought than in the US, whose reserve currency is dominant and whose policy rates set the tone for global cycles.

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But it’s not always true. Yes, the dollar tends to go up when the Federal Reserve is raising rates, but the correlation is much lower than you’d think. The dollar fell pretty hard across the board throughout the 2004-2007 hiking cycle, and if you look at 2017—a year we came into with an overwhelming consensus of rate hikes and dollar strength—we got rate hikes, but the dollar fell. Policy rates do matter and can be a powerful component of a narrative, but you don’t want to let the often mindless mantra of higher policy rates, stronger dollar blind you to other factors.

What are the other factors? My view of the dollar is that we are in the part of the global risk cycle where US-based capital looks at relatively full valuations at home and starts moving from core to periphery. In fact, this stop-and-go process started in early 2016. This is typically dollar bearish. Shorter-term, the central bank narrative is that of the Fed passing the hiking baton to the ECB, also dollar bearish.

The only problem is reality disagrees. At least for now it does. Yes, if you look at the chart of the EURUSD today you could, with enough mental gymnastics, imagine a scenario where the euro goes higher. And if the euro goes higher, it means the broad dollar is going lower. But, right now, I have three issues that are getting in the way of dollar bearishness.

One, the positioning is not favorable. By all accounts, investors are long euros. We can argue about how much and the extent to which euro positioning is a proxy for other currencies, but investors are short dollars. Because it’s easy to access, here’s the CFTC futures data for net spec positioning over the past 10 years as an example:

Two, the spread between the US 2-year yield and the German 2-year yield has not started to move. For evidence the baton-to-ECB narrative is taking hold, this needs to at least look like it might be forming a top. So far, its ascent is relentless.

Three, same thing for the spread between the US 10 year note and the German bund. Just doesn’t seem ripe for the full-blown narrative.

And, for the record, here is the 5 year chart of the euro:

Timing currency moves is a notoriously tricky business. It was just a few weeks ago that I thought the narrative of baton passing to the ECB was about to take hold. But today, despite the long-term view and scope for a bullish narrative in the coming months, it doesn’t look as though the stars are aligned. The good news: at least the euro looks like it will be strong in gold terms….

Good luck.