Macro Traders Couldn’t Care Less About Dollar Debasement Fears

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(Bloomberg) — It turns out the roaring reflation trade of 2021 is lifting one boat in particular in the foreign-exchange market — the almighty dollar.

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The greenback is wrapping up its best quarter in a year, with an almost 3% gain that’s allowed it to recoup roughly half its 2020 loss. The recovery has been fueled by a key trend gripping financial markets in the past few months: signs of strong U.S. growth that are driving a surge in Treasury yields relative to global peers.

For investors scouring the currency universe for opportunities, America’s massive economic-stimulus efforts and the staggering deficits they’ve produced, far from being an albatross for the dollar, have turned into a boon. That’s because they’ve created a backdrop where expectations for U.S. growth and inflation are rebounding to levels not seen in years, while many other major economies appear to be stuck in neutral, at least in part because of sputtering vaccination campaigns.

© Bloomberg U.S. yield premium over developed-market peers soars

There’s a clear way to grasp the stunning shift in investors’ assessment of who’s going to emerge most quickly from the throes of the pandemic — through rate differentials. Ten-year U.S. Treasury yields have surged to pre-pandemic heights versus the debt of both Germany and Japan, for example, a phenomenon that’s making it hard to bet against the world’s primary reserve currency.

The gap between U.S. and developed-market rates is “too big to be ignored,” said Abdelak Adjriou, a portfolio manager at American Century Investments. “What matters is the growth differentials — and the growth differentials this year are in favor of the U.S.”

Adjriou was among those who entered 2021 bearish on the dollar, a consensus view at the time. For many, the reflation theme and the risk appetite it fueled was a reason to sell the greenback, on the view that better opportunities would arise elsewhere as the global economy revived. The Bloomberg dollar index lost about 5.5% in 2020.

As the greenback sank, its share of global currency reserves slid in the fourth quarter to 59.02%, the lowest since 1995, according to International Monetary Fund data released Wednesday.

January Flip

But the narrative around the dollar flipped in January, which is when Adjriou says he turned bullish on the greenback versus the currencies of most major economies as Treasury yields took flight.

For him, the trigger came when the U.S. 10-year yield finally hit 1%, a level it hadn’t seen since March 2020. That move came in the aftermath of a runoff vote that delivered the Senate to the Democrats and paved the way for another immense federal stimulus plan.

Now the Biden administration is pushing for additional spending. Treasury yields are surging accordingly, leaving their global peers in the dust. The U.S. 10-year touched 1.77% Tuesday, the highest since January 2020. The yield on similar-maturity German debt is still below zero, while in Japan it’s barely positive.

Read More: Dollar Surge Spurs Leveraged Funds to Capitulate on Short Bets

“The U.S. has more growth engines working to their full capacity and that’s helping drive the rate divergence and dollar’s appreciation,” said Shahab Jalinoos, global head of macro trading strategy at Credit Suisse Group AG. Investors “are relatively confident U.S. growth will be robust but have increasing questions about other parts of the world. This backdrop, especially after the dollar’s weakness last year, creates a constellation for generalized dollar strength.”

The dollar’s appreciation can be a double-edged sword for the world’s biggest economy. On the one hand, it makes imports cheaper. But it also raises the cost for those abroad looking to purchase U.S. assets and exports, which risks slowing America’s growth rebound.

Speculators’ Rethink

For the moment, the widening growth and yield differentials are spurring a wholesale rethink of positioning in some corners of the currency market. Leveraged investors, for example, have flipped to net-long on dollar futures for the first time since November.

© Bloomberg Leveraged funds most bullish since July after flipping from bearish position

For investors pondering where yields go next, with Treasuries on track for their worst quarter since 1980 using Bloomberg Barclays data, there’s one crucial consideration: The Fed has signaled that it isn’t about to try to tamp them down, unlike some of its counterparts abroad.

Year to date, the greenback has gained versus most Group-of-10 peers. Among the highlights are a roughly 7% advance against the yen and a jump of about 6% gain versus the Swiss franc, two classic, low-yielding havens. It’s up around 4% versus the euro.

Read More: How the Reflation Trade Roiled Global Markets in Seven Charts

“U.S. exceptionalism has begun to return to the market over the last month or so because of the country’s growth outlook,” said Antony Foster, head of G-10 spot trading at Nomura International. “What we’ve seen recently is faster money like hedge funds and more active corporates beginning to build long dollar positions. The conviction for its weakness has diminished.”

Fair Value

Valuation could offer a further tailwind for the greenback. Among arguments cited by bond bears last year was that it was expensive. Now the dollar is closest to fair value in five years, according to a Bank for International Settlements metric known as the real effective exchange rate. A year ago, it was overvalued by nearly 20%.

The greenback has also cheapened on a trade-weighted basis. A Deutsche Bank AG trade-weighted dollar index has fallen around 9% from a roughly 17-year high reached in March 2020.

© Bloomberg Greenback on trade-weighted basis has tumbled over last year

The path of the Fed remains paramount. While officials have signaled they won’t raise rates at least through 2023, derivatives traders see a risk that the shift could begin as soon as late next year.

A report Friday is expected to show a significant pickup in U.S. job growth in March, with the unemployment rate sinking to the lowest in a year.

Morgan Stanley predicts the Fed will announce in January the start of a tapering of asset purchases. The bank expects the Fed to reduce the buying gradually and end it by December 2022, before hiking in the third quarter of 2023.

“What’s going to be really important for what the market thinks is next for the dollar is the potential for U.S. growth to exceed that of the rest of the world,” said David Adams, head of foreign-exchange research for North America at Morgan Stanley, which turned neutral on the dollar in January after being bearish since late March 2020.

“And U.S. interest rates will be a key factor,” he said.

(Adds IMF reserve data in seventh paragraph.)

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