By betting short-term currency rates and US bond yields higher over the past 20 months, the Fed has essentially sucked cash from the broader investment world and supercharged dollar rates everywhere. Now that it looks over, the bull is finally on the back foot – plumbing levels not seen since August.
In what ING strategists Chris Turner and Francesco Pesole describe as the dollar’s “long goodbye” – 2024 looks set for a persistent, trend-setting bear market for the greenback, which in itself will collapse volatility as risk markets feed back on the back of central bank weakening hope. .
“Talking about ‘reflationary’ policy now seems criminal – but the Fed has a dual mandate, and if inflation is kept under control until 2024, it can cut rates to improve the impact on the workforce,” the ING team wrote, adding. commodity currencies within the G10 were favorites for 2024.
With implied volatility biased in the direction, the dollar index and the CVIX are usually well correlated and both peaked in tandem in the same month of September last year.
That bias is mainly due to the disruptive aspect of dollar strength – which adds to economic, trade and financial stress around the world by inflating commodity import prices as well as squeezing dollar debts in many emerging nations.
That sensitivity, in turn, creates friction and often leads to extreme more extreme monetary policies or even open market intervention to push back – and making a sharp dollar ascent noisier along the way.
The side is more serene for the same reasons in reverse.
‘NORTHWEST PASSAGE’
Nowhere is this clearer than in Japan, where Fed tightening met with persistent easy money and yield-restriction policy at the Bank of Japan has sunk the yen. JPY= to 33-year lows and drew at least one attack of intervention, as the government and BOJ tried to draw a line under the yen while the dollar operated through 150 yen.
But with peak rates from the Fed meeting through BOJ – and both at least tilted in opposite directions next year, then dollar/yen finally pulls back in earnest and the two-point premium on dollar/yen. JPY3MO= over euro/dollar EUR3MO= implied vol splits as well.
For the euro EUR= and sterling GBP=, the dollar’s damage was enhanced by the parallel tightening at the European Central Bank and Bank of England. And a Fed pivot will most likely be matched or even preceded by them on the downside.
While US-Japan three-month interest rate spreads are the widest since 2000 and still at those peaks, US-German and US-UK equivalent interest rates have never topped 2018 highs and both are falling again.
And while a Fed rate cut is now priced into futures ahead of June, so is a BOE cut – and ECB easing is baked into money markets as soon as April.
There is not much wiggle room for relative currency trades then and volatility is further contained.
And of course these moves have a habit of feeding off each other, not least as a fall in implied volitional flows carries trades to higher interest rate currencies – not just within the G10 space, but to emerging markets and beyond and reversing the Fed’s vacuum. cleaner for the past two years.
As the ING team points out, the yen would usually also suffer in that regime because it usually acts as the cheapest financial currency. But a BoJ policy change is likely to cut across that.
Sure, the waiting game could see some stasis re-emerge. UBS Global Wealth Management’s Solita Marcelli thinks this week’s slide may be “exaggerated” as Fed thinking becomes clearer – although selling dollar piles probably makes sense in the interim.
But the abrasive rebound in US Treasury yields through October – as a “period premium” on Treasuries re-emerged due to concerns about fiscal policy stasis and rising debt levels – may well have kept the dollar higher than volatility levels would otherwise suggest over the past two. months
And so with yields falling again and the term premium now sliding back into negative territory after just two months, there may be a case for dollar weakness to play catch up.
The alternative take is that the buck is not done yet and may not give the ghost until the Spring.
Morgan Stanley believes the DXY index could rebound as much as 8% from here to around 111 before finally falling back later in 2024. The argument is that near-term direction remains cloudy as rate differentials are likely to continue to favor the dollar through the first half of the . year while growth and geopolitical risks support maintaining a defensive stance in dollar cash.
“Just like the Northwest Passage in winter, the path to a weaker dollar this winter is narrow, cloudy and fraught with risk,” Matthew Hornbach and team told clients this weekend.
And yet if vol is anything to go by, the clear water is already visible.
The opinions expressed here are those of the author, a Reuters columnist
Currency volatility returns to pre-Fed rate levels
Morgan Stanley charts US growth and relative real policy rates
ING chart on G10 FX rates and carries
The race to raise rates
The Fed’s policy sprint, and an evolving pause
(Editing by David Evans)
((mike.dolan@thomsonreuters.com; +44 207 542 8488; Reuters Messaging: mike.dolan.reuters.com@thomsonreuters.net @))
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