Here’s What To Watch For In The Suddenly Resurgent Dollar

Guess what? The dollar just had its best week in 17 months.

But you already knew that, right?

This is a function of a variety of (obviously) interrelated factors including the restoration of the greenback’s positive correlation with 10Y yields, rising short-term rates, and assumptions about the Fed.

Those factors (really, they’re all just part of the same story) have together been enough to override concerns about the deteriorating U.S. fiscal condition and have trumped (get it?) the fact that the administration has effectively adopted a weak dollar policy by proxy with their combative approach to trade (and if you don’t believe that, well then just ask Steve Mnuchin).

The recent rally in the dollar comes at a particularly inopportune time for a whole lot of folks. We touched on this a bit in “Cracks In The Carry Trade” and also in “‘Herd’ On The Street: Crowded Trades Get Slaughtered As World’s Most-Followed ‘Strategist’ Proven Right.” The bottom line: whether it’s EM, crude, or FX, there’s a lot riding on a subdued greenback. Here’s Nomura’s Charlie McElligott from a Tuesday note:

Nearly every consensual macro trade has an implicit short-dollar view built-into it. A dollar squeeze is a major risk to longs including emerging markets, crude oil, the Nasdaq, the euro, the yen and industrial metals.

As Goldman notes, the USD net short in FX was pared a bit last week (down $4.4 billion to $23.4 billion), but that’s off a seven-year high. Here’s the latest breakdown:

Of course some of the spillover that you’d expect in commodities from a suddenly resurgent dollar has been muted by geopolitical turmoil that’s driven crude to fresh three-year highs and recently jolted the metals market. Whether or not that’s sustainable is an open question.

Whatever the case, it’s safe to say that a continued appreciation in the dollar will have all manner of ramifications across assets and for those of you wondering what to watch going forward, BofAML has the following helpful guide.

Via BofAML

Two weeks ago we argued that FX was dead and that only the USD could bring it back to life. We saw some evidence of this in recent days, as the USD has finally started appreciating. It is too early to know if this is the USD rally we were expecting and how far it could go. There was no specific trigger in our view, just an accumulation of good news that should had led to a stronger USD well before, and a short market position. To determine whether the USD will continue appreciating, consistent with our call, and by how much, we would advise investors to focus on the following:

• US data and particularly inflation. US data has been strong this year, despite negative Q1 seasonality. Will the data remain strong, or even strengthen further, as seasonality improves and the fiscal stimulus affects the economy?
• Fed. Our economists are with the dot plot all way, but markets are pricing the end of the Fed’s tightening cycle next year and a high probability of a US recession in the next two years. If the US data remains strong, will the consensus converge to the dot plot, and when?
• Profit repatriation. Last week we saw strong corporate USD buying, but it is too early to know if profit repatriation has started. We are optimistic, expecting profit repatriation in the months ahead, some of which will include conversion into USD. Once it starts, we would expect markets to be surprised and start pricing what could follow. Is profit repatriation around the corner, as we expect, or it will take longer?
• Trade. We expect a NAFTA deal and compromises with China on the latest trade disputes. Doing otherwise would make everyone worse off, in our view. Surplus economies would suffer the most, but we would expect a US-driven trade war to hurt the credibility of US policies more broadly and be negative for the USD. Are we going to see trade deals, which is our call, or a trade war?
• Flows. Our proprietary flows have started showing USD buying by both real money and hedge funds in recent weeks, from a short position. This is however being offset by official sector USD selling. Our analysis suggests a long-term diversification trend away from the USD, but recent USD selling has gone beyond this trend and we suspect has to do with fears of trade protection. If we are right about imminent trade deals, we would expect central bank USD selling to slow back to the long-term trend, allowing the USD to rally in response to strong fundamentals. Will central banks stop selling the USD in the months ahead?