A Lack Of Hawks Are Making USD Bulls Rightfully Nervous

The one where Ex-President of the Dallas Federal Reserve said they needed to prop up the asset prices in hopes that the economy would follow.

The Fed is intimately familiar with the health of banks that support the economy as well as the major indicators of the global economy.  When they say that all is well in the economy and that they’re waiting for other economies to ‘pick-up steam,’ investors have bought assets (mainly commodities, emerging market debt, and stocks) and played the patience game.

‘Fed knows best,’ or so the thinking goes. However, with fewer hikes projected and fewer still delivered, the Federal Reserve is looking like the Fed ‘who cried, Wolf.’ The boy who cried wolf is a fable about a boy who was able to stir up panic in a village by warning of a wolf coming to ravage their goods and homes. The villagers stopped everything to prepare for the wolf’s coming but never saw the wild animal to the humor of the boy who made the story up. Once more, the boy warned the villagers, and once more, they stopped everything and focused on preparing for the wolf-attack. The boy laughed as the fabled wolf failed to show up.

Later, however, as a wolf began to approach finally, the boy warned the villagers again. This time, the villagers didn’t want to be bothered with a made up story about ‘impending doom’ and carried on with their life. Unfortunately for all, the villages guard was down because the boy had led the villagers astray and the villagers were numb to the warning because they had lain to about the dangerous event.

So, what does this have to do with the FX Market and the US Dollar? Since then-Chairman of the Federal Reserve, Ben Bernanke began warning of rate hikes in 2012 to prepare the market, the net outcome 4-years later has been one-0.25 basis point rate hike.

Naturally, the market is comprised of speculators and hedgers both large and small. While this is over-simplified, speculators tend to be forward looking while hedgers tend to be backward-looking.

Given much of the strength mentioned from previous US Dollar rallies in 2012/3, H2 2014, and late 2015, much of the long exposure (new buyers) in the US Dollar right now are corporate hedgers.

As of mid-May, Hedge Funds had their largest net short US Dollar position on since before the H2 2014 rally or nearly in 2 years. The reason many have sighted for going short is that they do not believe the Fed will do what they said they will do. They have become like the ‘Boy Who Cried Wolf,’ and speculators are calling them out.

While we have seen a rise over May, many doubt the ability of the Fed to match the expectations the current buyers have for new highs in the US Dollar.

Additionally, if the market sees the Fed as ‘knowing something I don’t,’ we could see a reversal of the prior move on their optimism. In other words, the emptiness of their words could prove to be the undoing of much of the confidence they helped create.

Should that confidence begin to crater, as evidence from hedge fund FX exposure suggests is happening, US Dollar selling could develop and develop quickly?

Unfortunately for many, this would like also extend toward equities as US Equities and the US Dollar has tracked similar paths since 2011 when the US Dollar bottomed.

Fortunately for a few, this could benefit select emerging markets as well as commodities like Gold that are seen as a haven asset when central bank faith hits the skids.

Trade Possibilities?

So how does an FX trader play this game? The Federal Reserve has been promising tightening that has led to many traders buying the US Dollar to play monetary policy divergence. The phrase ‘monetary policy divergence’ simply means the diverging or opposing paths that central bankers have for their monetary policy.  The idea favors buying the strong currency (currency with the more optimistic or hawkish central bank) while selling the weak currency (the currency with the more pessimistic or dovish central bank.) This phrase can also be used to ensure you don’t get invited back to happy hours or cocktails parties.

However, since 2011, with Federal Reserve Interest Rates sitting at the zero-bound, many traders have bought or held US Dollars relative to other currencies on dreams of multiple rate hikes by the Fed.

The question I would like you to ponder with this article is simple and is based on what has been covered so far. The idea is:

What happens if the world went long US Dollar on the assumption of the interest rate normalizing toward ~2% (roughly seven rate hikes from current levels), and all we get is a couple more?

In other words, will traders continue to stay in their long US Dollar trade for the current projection that has had a history of weakening?

If the Federal Reserve decides they’ve over-promised only to under-deliver the number of rate hikes ultimately, the market could begin letting go of US Dollar long hedges (held by corporations after the ugly surprise in H2 2014)

What Might Be Bought If the Us Dollar Drops on Lack of Fed Follow Through?

For now, it appears that the JPY remains the FX currency of choice. If you were to take a look at the options market to see what kind of premium investors were paying for puts as opposed to calls (or downside vs. upside bias), you would see the most expensive downside protection is on JPY crosses that would indicate potential JPY strength.

If a strong JPY fails to play out, it appears that commodity currencies like the Australian Dollar, Canadian Dollar, and New Zealand Dollar could benefit nicely from the US Dollar fall-out, as well as the EUR. As of May 10th, the Commitment of Traders Index showed that the difference between net speculative positioning and net commercial positioning measured a 52-week extreme with hedge funds or Non-Commercials (speculators) at their most extreme bullish position in the EUR since summer 2014.

Conclusion

The Federal Reserve has inherited a problem. If the economy is too weak to hike rate, they will continue not to hike. However, much of the current market pricing is under the assumption that the economy is strong enough to support promised hikes.

If the Fed fails to hike, even if it is completely justified, it may mean that a US Dollar downtrend, unlike one we’ve seen in at least three years, if not longer, is under way.  Should that develop, it’s natural for traders to explore what new trends will develop and exploit them when they’ve proven durable.

Active Reader Help

1) What are the major points in this Article?

A Lack Of Hawks Are Making USD Bulls Rightfully Nervous . If the Federal Reserve continues to underwhelm investors by not hiking rates, US Dollar longs may begin to bail on their multi-year trades.

The Fed has done a masterful job of keeping risk sentiment high while talking up the strength of the economy and accommodating at the same time.

2) How can I apply or extend these ideas?

Be on the watch for the Federal Reserve to disappoint markets again where they fail to deliver the number of hikes the market is expecting. At some point, the current long exposure in the US Dollar could give up, and a new US Dollar downtrend could emerge. 

Happy Trading!