The "long dollar" trade may be the most crowded ever [10]...
...but that doesn't mean there aren't disagreements where the greenback goes from here, especially after the Fed's historic first rate hike which according to some means the end of the dollar's tremendous year-plus long rally as the market starts to price in the next recession as a result of the Fed's own action, while according to others as a result of rate differentials and other central banks' ongoing debasement of their own currencies, the dollar surge is only getting started.
Among the latter, is none other than infamous Goldman FX strategist Robin Brooks, whose recent firm conviction that the ECB would crush the EUR led to massive losses for anyone who listened. This time, Goldman is intent on making anyone who still isn't onboard the long-USD monorail, shown originally here in this January 2015 post [11]...
[12]
... get right on board.
From Goldman's FX team explaining why "they hiked it and they liked it"
The Fed today raised interest rates for the first time since 2006, without – as our economists note – resorting to an overly dovish message. This was very much in line with our “hike it and like it” expectation and markets responded in the way we anticipated: the SPX bounced, EM currencies like the Mexican Peso strengthened, buoyed by the recovery in risk appetite, and the Dollar rose versus the G10. The turning point for price action came in the press conference, when Chair Yellen did not use a question on credit markets to head in a dovish direction, but emphasized the soundness of the financial system and strength of the economy instead (Exhibit 1).
[13]
As we argued prior to the meeting, risk markets tend to take direction from the Fed when uncertainty is elevated, as in September when a dovish FOMC caused risk to sell off, while risk rallied on the hawkish October statement. This pattern held true today, as Chair Yellen’s upbeat message helped markets put aside worries over credit markets.
Yes, sure, let's just forget the terrible September jobs report which unleashed the tremendous October market surge on hopes of a dovish Fed, which then magically morphed into a narrative that it was a hawkish Fed that is good for stocks all along. Anyway back to Goldman:
The biggest beneficiary in G10 FX was $/JPY, which moved higher on a double lift via rate differentials and the relaxation in risk aversion. Into year-end, long $/JPY is our favorite expression of Dollar strength, as aggressive QQE implementation from the BoJ – 10-year JGB yields have been anchored at 30 bps through recent market gyrations – has on multiple occasions given rise to “phantom” moves higher in this cross, which we think reflect the power that QQE has on domestics shifting their portfolios out of JGBs into risk assets and out of the Yen. This channel, incidentally, is not operating as effectively for the Euro, where the volatility in Bund yields since May and the most recent press conference have undercut the effectiveness of QE.
As yes, the Euro. Let's recall what happened to that particular Goldman recommendation. On second thought, let's not and let's give the podium back to Goldman:
There is no doubt that 2015 was a difficult year for the divergence trade, notably EUR/$ lower.
Yes, that's one way of putting it [14].
But we don’t think there is a mystery as to what happened. Disagreement within the ECB has hampered the implementation of QE, which was one driver that caused the bounce in EUR/$ from 1.05 to 1.14 and temporarily put the Dollar on the back foot (the other driver being the dovish shift from the Fed at the March meeting). We certainly do not subscribe to the theory that Dollar strength is over now that lift-off has occurred, which is a popular view in some quarters given the behavior of the greenback during past hiking cycles. We think such historical comparisons ignore what a unique policy experiment has just ended: an emergency setting for policy rates since 2008, large scale asset purchases that more than quintupled the Fed’s balance sheet, and forward guidance that prevented interest differentials from moving more strongly in favor of the Dollar. The unwinding of all this will on our estimates drive the Dollar around 14 percent stronger through end-2017, with front-end rate differentials continuing to dictate that move (Exhibit 2). The Dollar is a buy.
For the benefit of those who are not convinced, and who have been kermitted one time too many, here is BofA Merrill Lynch with the variant perspective:
The dollar was mixed in the aftermath of the FOMC today with the market nearly fully priced for the first hike in 9 years. The still optimistic tone of the statement with respect to the labor market and growth, the unlimited ON RRP facility (strengthening the Fed’s ability to control short-rates) and with the dot plots still signaling 4 2016 hikes, the USD initially rallied--though later retraced—price action inconsistent with market’s expectation for a dovish hike. However, the USD’s experience of strengthening the 3-6 months into the first Fed hike, only to selloff in the months after, leaves us hesitant to read today’s Statement and Press conference as unencumbered bullish USD factor. More specifically, net USD long positioning was still quite high heading into the meeting, therefore, the USD’s retracement was likely a reflection of position adjustment than a fundamental catalyst. The mixed price action suggests today’s meeting will not be a near-term catalyst for the USD to rally further.
Dollar performance going forward (now that the Fed has started the normalization process) will depend on: First, US data and the pace of hikes—if the Fed is able to hike 4 times next year versus the 2 priced into the market, the USD will move higher in our view, particularly against a backdrop of further policy easing by the ECB and BOJ in 2016. A sharp RMB depreciation could slow the pace of USD appreciation, in our view. And second, equity performance which, in part, will reflect the market’s assessment of the ability of the economy to handle higher rates (and a higher USD). Given the USD’s positive correlation with equities, any weakness here will likely hamper USD gains against funding currencies like the EUR and JPY in this scenario. Recent financial market volatility and the Fed’s still consistent message of conducting 4 hikes in 2016 (vs only 2 priced by the market) make us cautious on this front.
And there you have it: two opinions, two diametrically opposite conclusions.
Confused? That's the point. However, if one had to come up with a coherent trade from all of the above, it would be to go alongside Goldman's prop traders, which is by definition precisely the opposite of what Goldman's clients are advised to do.
