No note on currencies can be taken seriously these days without at the outset swearing fealty to the mighty greenback. In short, it seems the state of the currency is sound.
And I don’t disagree. The medium term fundamentals, in terms of interest rates and growth, do still favor the USD. But does this mean it will continue to rise? Currencies are fickle things. Expectations play an outsized role in an asset class where there is no tangible value or hard measurement. And everyone has baked a stronger USD into their base case for whatever they’re doing. Everyone. Current expectations have set a high bar for dollar appreciation.
This is the story I could easily see playing out in currencies in the coming weeks/months, given current expectations and positioning. And it is not bullish the USD.
- US rate hike. The most dollar bullish scenario is the one where the FOMC hikes in September. No one anywhere would be truly surprised if the Fed hikes rates next month. It may only be about a 60/40 proposition, but no one would be left slack-jawed. Okay, maybe there are a handful of QE4EVA crazies somewhere huddled in a bunker with Obama birthers insisting they will still be vindicated. But if the FOMC raises rates in September—or the market starts to price a much higher September probability—and it fails to boost the dollar further, there will be a lot of investors bailing out of their entrenched long USD positions, most of which are predicated on higher rates.
- Pace of hikes. It seems unlikely that the FOMC will indicate a pace of hikes aggressive enough to sustain the degree of positioning and sentiment that is currently behind the long USD trade, especially, if, as I suspect, the Fed is hiking more as avalanche protection and not because they fear economic overheating.
- European growth. Much of the dollar’s rise has been Europe’s fall. And expectations in Europe are now very low. Less recession would constitute a win there. Moreover, Greece has been taken off the table as a systemic risk and the ECB have made it clear that they will protect sovereign spreads if pressured. This means EZ breakup can only come from within, in response to protracted worse-than-expected growth. This risk is real, but it is likely much, much further down the road now. Lots of room for surprise to the upside.
It’s always a dicey call to fade the fundamentals—even after a big run. But when sentiment, positioning, and expectations rise to certain levels they require ever more powerful news to be maintained.
It wouldn’t take much here to send to USD longs/EUR shorts into a scramble. And it would take even less to make a compelling narrative out of it.