Fall Guy

Via Kevin Muir of “The Macro Tourist” fame

In July I wrote a piece titled, “Is the real US Dollar Pain Trade Lower?”. At the time the US dollar was sucking wind, but many traders were still playing for a bounce. The prevailing wisdom was that the Fed’s tighter monetary policy, combined with Trump’s business acumen, along with a tax reform bill, and topped off with a massive short covering surge from emerging market US dollar denominated issuers, would ensure the two-year US dollar rally would continue.

In the article, I quoted Luke Gromen, who said, regarding a move down to 80 in the DXY, “…while COT (committment of traders) [data] shows more are cautious on the USD, as best I can tell, there isn’t a soul that thinks this kind of move is even possible.”

Yup, Luke was bang on correct, during the summer, precious few believed the US dollar would go down, forget about plunging more than 10%.

Earlier this year, according to most market participants, US dollar strength was inevitable due to all the reasons I suggested. Although Luke had been arguing his US-dollar-loss-of-reserve-currency-status theory for quite some time, apart from Grant Williams and some other hard money guys, Luke’s theories were not gaining traction. Hedge funds were much more enamoured with the soothing sounds emanating from the USD bullish investing crowd. The idea of the US dollar losing its reserve status was laughable. I remember suggesting something to that effect to a colleague and he chuckled, “what will possibly replace the US dollar? The Euro? The Yuan?”

Yet today, Luke is a rock star whose theories about the loss of US dollar reserve status are all the rage. Hedge funds and other traders are positioning their portfolios to take advantage of the coming US de-dollarization.

Now, don’t misconstrue this next part of my argument. Luke is a unique, big picture thinker that everyone should take the time to understand. No sense rehashing his arguments. Instead, if you haven’t listened to it, head over to MacroVoices to hear Luke’s interview. Although I agree with Luke’s long term conclusions, my quibbles have all to do with the timing of this inevitability.

Too many traders are expecting this to happen tomorrow. I have learned never to say never, but I don’t think this sort of accelerated timing to be a high probability move. The de-dollarization of the financial system will not be an overnight event. It will be a long drawn out process. And in the meantime, the US dollar will go down, but more importantly, it will also go up. Let’s not forget that there will be plenty of cyclical moves within a secular bear market.

Although I want to be bearish on the US dollar along with everyone else, I have learned the hard way that in today’s market, this is not the correct bet. Over the past decade, trading has transformed into a zillion hedge funds arranged in a circle shooting at the tiny piece of alpha in the middle. Often the best trade is to fade the hedgies, regardless of how compelling their reasoning sounds.

Taking the other side of this latest de-dollarization fad feels scary. It is not comfortable by any means. As I write this piece, I want to erase it and start over with another topic. Yet the hard trades are often the right trades… (either that, or you make a complete fool of yourself)

I am not sure what the catalyst will be for a US dollar move to the upside. Maybe it is a Fed that returns to their relatively hawkish ways. Maybe it will be an ECB that somehow manages to get the Euro to stop rising (as an aside, today the Euro poked its head above 1.20, and mysteriously, “sources” hit the financial news tape to jawbone it lower. It sure feels like the ECB doesn’t want the EUR above 1.20) Maybe China or Japan, or whoever is the hot money these days, returns to buy US fixed income – after all, the US dollar is as cheap as it has been in quite some time. Regardless of the reason, the next surprise will not be a US dollar bear move, but instead a rally that catches everyone off guard.

Maybe I am early. Could be. Actually, it’s most probable. There is also a chance that I am outright wrong, and that Luke’s de-dollarization theory plays out much quicker than I expect. But I think the higher probability bet is that hedgies and the rest of the investing community got way too bullish on the US dollar over the past year. They got hurt, unwound it, and are now trying to make it back with a downside bet.

We have now hit the point where practically no one is recommending long positions in the US dollar. Well, lonely trades are my favourite kinds. I am buying US dollars, with the idea that I will leg into the position – half now, and half if it breaks to new lows. In yet another one of my painful lessons, I have learned that stepping in front of trending crowded trades is not easy. There is no rush. And most importantly, be careful! Volatility increases at turning points. Remember, the bottom is always lower than you expect.