Probably the most crowded trade in play today is on the strong dollar. Divergent monetary policy outlooks, interest-rate differentials and expected growth trajectories all favour the dollar and the United States versus Europe and Japan. This has become a consensus trade and key investment theme for most macro funds. Many believe that the dollar has begun a multi-year secular up-move similar to what happened in the early 1980s and the mid- to late 1990s. In many recent surveys, more than 80 per cent of hedge fund managers surveyed expected the dollar to be the best performing currency of 2015. Other data on investor positioning show that we have had record levels of dollar longs.
Whenever there is so much consensus around a particular trade, it always make sense to challenge the conventional wisdom and see where the crowd could be wrong. This is especially so when the consensus is around a critical variable like the dollar's value, probably the most important relative price in global financial markets.
Some market observers have begun taking the opposite view to the consensus. The contrarian view is as follows:
If you look at the recent history of the dollar, there have been two periods of very large moves. The DXY dollar index surged by 95 per cent in 1980-84 and then by 51 per cent in 1995-99. Independent of these two mega moves, as HSBC points out, the average rally in the dollar (reflected through the DXY index) has been around 20 per cent and lasted for about a year. The current rally has already crossed this average, with the dollar rising by about 25 per cent since June 2014. If you go back and track the move from its low in April 2011, it has surged 40 per cent. The contrarians make the point that this is already a big dollar rally. Unless one is convinced that this is a new secular mega cycle, like what we saw in the early 1980s and late 1990s, we should be near the end of the move.
The two secular upcycles in the dollar came in times of robust US growth and tight monetary policy. Both were also marked by huge risk-aversion flows, given the crisis in the emerging-market world at those times. We had the Latin American debt crisis in the early 1980s and the Asian crisis in the late 1990s. In both these cases, the dollar was at the centre of the crisis, as lenders refused to roll over dollar-denominated debt, causing a spike in dollar demand and a surge in the currency. While there is once again concern around the vulnerability of emerging-market companies to the rising dollar, we still seem to be far away from any solvency crisis.
The dollar bulls can make the point that more than dollar strength, what we are seeing is euro or yen weakness. The policymakers in both these economic blocks want to depreciate their currency as a way to boost growth and stave off deflationary tendencies. Under the influence of quantitative easing (QE), these currencies will overshoot versus the dollar. If one were to see the experience of the US currency when that country was in the midst of its own QE episodes, the dollar depreciated by about 20 per cent during QE1 and by another 20 per cent during QE2. The weakness in the yen (-35 per cent) and the euro (-25 per cent) are already equal to or greater than that experienced by the dollar through QE. The effects of currency debasement are already manifest in current exchange levels.
The main cause of dollar strength in the last 12 months has been the monetary policy divergence between the United States and Japan/European Union. The contrarians argue that this is now fully reflected in investor positioning and prices. Markets now fully expect the US Federal Reserve to raise interest rates this year - there may be a debate around timing and pace, but a rate hike is already embedded into market pricing. Similarly, the European Central Bank (ECB) has finally embarked on QE, and the Bank of Japan has clearly signalled its intent to remain aggressive. As opposed to 12 months ago - when there was a great debate about whether ECB President Mario Draghi could get his QE pushed through despite German opposition, or whether the Fed would be able to raise rates - expectations are now more firmly set and there is little scope for surprises. The big currency moves happened as investors finally got over their wall of worry on both euro-zone QE and the Fed hiking. There is no further wall of worry to climb to sustain the move.
The dollar has been so strong partly based on expectations of relative economic growth as well. The consensus expects the United States to grow at at least three per cent in 2015, while the European Union and Japan will grow at one per cent at best. These are the expectations built into the current exchange rates. The reality is that over the past few weeks, the US data have been consistently undershooting, with all economic surprise indices turning down - the exact opposite of the euro zone, where the surprises are all positive. I would not be surprised to see forecasters cut US numbers, while raising their growth estimates for the euro zone, driven by falling oil prices, a weak currency and the absence of a fiscal drag for 2015. A shrinking growth gap between the United States and Europe should normally be positive for the euro, though the markets seem to be ignoring it for the moment.
The reality is that, as HSBC points out, on various measures the dollar is now the second most overvalued currency in the world, after the Swiss franc. There also seems to be growing discomfort at the Fed on the strength and trajectory of the dollar. The rising dollar is an implicit tightening of monetary conditions and the Fed's own models indicate an almost 50-65 basis-point impact on growth from the strong dollar. Via the strong dollar, the United States is implicitly importing disinflation, and most inflation data are surprising to the downside. The Fed is clearly looking at the dollar and the damage it is causing to both US growth and inflation. We may not see benign neglect towards the currency forever, and definitely not if the dollar were to continue to strengthen as the consensus seems to indicate.
The other interesting data point is that history shows that the dollar has fallen in the period immediately after the first rate hike by the Federal Reserve.
The consensus is convinced that the dollar is a one-way bet and will continue to strengthen. Most are already positioned for this, and it is a very crowded trade. It may make sense to think of how the consensus may be wrong. There may be no sharp reversal, but at the minimum the unrelenting rise of the dollar may be over. It may be range-bound from here.
If the dollar were to remain range-bound, that would hopefully take some pressure off the rupee, which continues to remain overvalued. The cross-currency effects across corporate India have been devastating to profitability. The rupee should weaken against the dollar, ideally; but absent that, a stable dollar will at the minimum reduce further incremental cross-currency pain for Indian companies.
The writer is at Amansa Capital. These views are his own
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
