The year of the dollar bull

By:
Solomon Teague
Published on:

It has been a year of two halves for FX, with an opening seven months characterized by low volatility and few attractive trading opportunities for FX managers, before a dollar bull market roared into life in August. It is arguably the first such market for 20 years, bringing with it a rise in volatility and enhanced opportunities for FX traders.

It has been a long time coming. Markets have been watching the dollar closely, wondering when it would awaken. In August – ironically, a time of year when the markets are usually at their quietest – it finally happened.

Andreas Konig-large
  It is easy to underestimate the potential for dollar strengthening after
so many years of
range trading

Andreas König

"Everyone [in 2014] was waiting for the euro to fall and the dollar to rise against most currencies," says Mohammed Grimeh, regional head of financial markets for the Americas at Standard Chartered.

"The Fed had been preparing the market for the end of quantitative easing (QE) and monetary tightening for a long time, while the European Central Bank (ECB) and Bank of Japan (BoJ) were expected to ease and stimulate their economies. There was no real surprise in 2014 among the G10 currencies, but the market has had to wait a long time."

While technically the market is still waiting, with US rates unchanged and the ECB still dithering about QE, August marks the point at which the market reacted to the anticipation, if not the events. The watershed was transformational for FX, triggering a US dollar rise that is now being described as a dollar bull market – rather than merely a correction. Now everyone is excited about a lively 2015.

Andreas König, head of FX Europe at Pioneer Investments, says: "The FX asset class is completely different depending on whether the dollar is in a bull or bear market. In a dollar bull market, everything is driven by the dollar; smaller currencies in particular become much less important. The world becomes more black and white, depending on your view on the dollar."

Although the return of volatility has FX traders rubbing their hands with anticipation, there is a downside, spelling, as it does, the end of cheap dollar-denominated funding. Along with Chinese growth, this has done much to turbo-charge global growth in recent years.

David Woo, head of global rates and currencies research at Bank of America Merrill Lynch (BAML), predicts a challenging year. "The obvious trades such as the long US dollar trade are already crowded," he says. "There also may be more volatility than trends, which means making money could require more frequent tactical manoeuvres."

The trick

The trick will be finding other trading opportunities at a time when most central banks are looking to weaken their currencies, and timing the market. The UK election has traders particularly flummoxed.

FX_G10_4_GBP.


Steven Englander, global head of G10 FX strategy at Citi, says: "Investors don’t see any positive outcomes for GBP, with a Labour majority/coalition bad for business and Conservative majority/coalition raising prospects of Brexit."

For most currencies besides the dollar, it looks like a race to the bottom. The Canadian dollar will be squeezed by its rate differential with the US, cheaper oil and poor competitiveness, while the Aussie is also hurt by weak commodity markets undermining its terms of trade with China.

FX_G10_3_AUD


Yet some will have to rise against each other. "Notwithstanding the ECB’s heroic efforts to talk down the EUR, the eurozone trades with a lot of countries whose exchange rates are as weak as, or weaker than, the EUR, so there is more work to be done to avoid the zero inflation threshold," says Englander.

FX_G10_1_euro


However, overall euro weakening has much further to go, says Englander, adding: "We see EUR as a third-to-a-half of the way through a long-term weakening cycle and that stabilization of the currency isn’t likely until sometime after 2016. The key theme for 2015 is to avoid getting flattened by an occasional correction."

A more difficult call will be how the other big currencies trade against each other, ignoring the dollar. Everyone agrees euros and yen are set to slide against the dollar, but how will they fare against each other?

Standard Chartered’s Grimeh says: "EUR/JPY is a tough call, but if I was pressed I would go long euros against yen, simply because the BoJ is ahead in its QE programme including quantum, and its recent election outcome has confirmed broad support for its current policies.

"In Europe you have Germany and most of northern Europe that could resist or put the breaks on any full pledge for QE and currency depreciation. On the other hand, consensus appears to point to downside in euro. 1.12 EUR/USD is priced as more likely than 130 USD/JPY"

However, as one of the few real candidates for currency strength, the real upward pressure is on the dollar.

Pioneer’s König says: "If every currency wants to weaken, they need something to appreciate against and only the dollar looks capable of absorbing that level of strength. The question is how long it can last. If inflation or growth dip in the US, things can change pretty fast, but until that happens I expect the trend to continue."