Anguish had ensued for months, with declining volatility seeming to compound the misery of the market, killing any potential trend. Traders in currency markets were being rebuffed by a currency that did not wish to rise. It had been the consensus year ahead trade at the beginning of 2014. The moves for much of the year seemed to “prove” that the consensus was wrong. Finally, over the summer, the dollar showed the market some love, rallying over 7% against the euro and against nearly every other currency in recent weeks. Perhaps consensus was actually right about the elements (see above) being here for a dollar rally?
The narrative which has been at the heart of the market’s desire to see a stronger dollar is fairly clear. I recently went to a talk by Mark Cudmore at a currency conference, TradeTech FX, in London. He has been in the currency markets for a decade. I have known him for nearly that whole period and I am always keen to here his thoughts on the market. His presentation was based on the premise that the market follows narratives, which can often overshadow other factors. In my experience, this becomes more evident, each year you follow the markets! Trying to point to fundamentals, whilst another set of narratives is in play and a dominant trend is sweeping markets, can be a painful experience even if the narrative eventually pivots to your viewpoint. There are countless examples not purely confined to currency markets. In the dotcom crash, investors who went short, hoping to profit from a fall in overvalued tech stocks, were eventually proved right. However, any investors who went short too early, would have been forced to close out their trades before they became profitable.
In currency markets at present, the market narrative is of a central bank considering when to hike, the Fed, whilst another is in easing mode, the ECB. Indeed, this has been prominent in most market research that I've read and in the media. This is the classic divergence play, which has so often been central to currency markets and has helped to trigger the rally in the dollar. It is the type of trade, which has been lost in the muddied waters of the past few years, where central banks seemed to be engaged in a race between one another for the bottom in yields. Much of the post-crisis period has seen markets driven more by shifts in risk sentiment than anything else. This contrasts to monetary policy expectations which are linked to expectations around growth and inflation. If we look at unemployment rates in the US and the Eurozone, we can see an illustration of why there should be some monetary policy divergence, in particular once the buffer of Fed QE has been eroded. I could show you numerous other plots to illustrate the same point. (Of course, there has been this divergence for years, but the market narrative was somewhat different!)
Figure – US vs. Eurozone unemployment
Indeed, the ECB has been easing policy, cutting deposit rates to negative territory and committing to purchase ABS. The potential for further moves, notably through the purchase of sovereign bonds remains a possibility. The Fed are still conducting asset purchases, admittedly in smaller sizes, and this will finally end in October. Of course the market is pricing in higher short end Fed rates and the Fed “dots” are also pointing to hikes. The “dots” are representative of individual Fed governors’ forecasts of future rate policy at various Fed meetings.
Figure – Fed dots and market pricing – In case you didn’t know markets expects the Fed to hike soon
UST 2Y yields have also risen, as we approach the end of Fed QE, which are traditionally the most important part of the curve for developed currency markets (by contrast to UST 10Y yields, which are markedly lower on the year). However, despite all these moves in the UST yield curve, the answer to whether the Fed have hiked is clearly “no”. Hence, the dollar is rallying partially on an expectation that hikes will happen soon. Whilst, I find it difficult to disagree with the view and I am (like the rest of the rest of the market) forever enamoured with a trend, we need to consider several factors.
Positioning in short EUR/USD trades is at an extreme, if we look at public sources such as the CFTC’s speculative net positioning data. Hence, this suggests that many market participants are already in heavily long USD. I know some of you will bemoan that I use this data, given that it is largely dominated by CTAs (those funds which predominately trade trend following strategies) and it is also quite lagged. However, in my analysis, I have found that it is generally best to go with the “flow” in CFTC positioning data. Hence, at extremes, it is generally profitable to follow it, but to be weary once it starts to pull back and traders begin the process of liquidating their positions. In particular, there is crossover point, where existing shorts can feel enough pain from a liquidation to force a squeeze which can be self-perpetuating. It also does begin to concern me when forecasts are rapidly being cut by many banks in succession, something that is happening to EUR/USD.
Figure – EUR/USD CFTC speculative positioning – is very short
On a broader point, price action often gets ahead of itself. One example, cited during Mark’s talk, was the rally in USD/JPY which began when in November 2012 and accelerated following the election of Abe in that December. In a Draghi-esque “whatever it takes” manner, Abe pledged to restart the Japanese economy with "three arrows" of fiscal stimulus, monetary easing and structural reforms (via FT/Wikipedia). The market’s love of Abenomics was perhaps even deeper than what we are currently witnessing for the dollar. USD/JPY rapidly rallied from around 80 to 95 from November to April, just before the BoJ’s historic meeting when they announced a massive program of QE. I have fairly vivid memories of that time, which felt somewhat electric from my viewpoint, working at the time of the currency desk of Nomura, a Japanese investment bank.
Figure – USD/JPY rally since 2012 and mentions of Abenomics in Bloomberg News
Since that historic BoJ meeting in April 2013, USD/JPY has managed to rally to 110. However, this second part of the journey higher has been fairly disjointed. In other words, the yen was weakening during a period where there were expectations of significant monetary policy easing by the BoJ, rather than actual easing. Does this sound familiar, a currency moving ahead of a central bank actually changing their policy? Furthermore, the most recent rally since August has come at a time of broad based dollar. Perhaps more of a dollar narrative playing out than a yen one at present?
As Mark remarked (I give no excuse for that pun) and what is so often said in the market, don’t fight the narrative. At the same time, we need to consider whether the market is getting ahead of itself. When will the motivation to take profits for market participants be stronger than following the narrative on the dollar? When the Fed does actually hike, will the market have already been exhausted by a rallying dollar? A great story only translates into profitable trades when the rest of the market also listens.
My book Trading Thalesians - What the ancient world can teach us about trading today is out in late October on Palgrave Macmillan, also has some colour on this generalised topic (mixed in with a bit of ancient history). You can pre-order the book on Amazon.