Reversal Shocks

Notwithstanding a Monday bounce triggered at least in part by a robust ISM services print which suggested the most important part of the US economy (where the “sticky” inflation lives) isn’t close to rolling over, the dollar is mired in a pretty deep slump.

In fact, another decisive move lower would threaten to negate the entirety of the rally seen since Nick Timiraos tipped the Fed’s intention to hike rates by 75bps for the first time since 1994 in June (figure below).

Already, the greenback has given back strength accumulated over the period encompassing Jerome Powell’s stern Jackson Hole address and September’s hawkish FOMC meeting.

Long USD was at the heart of 2022’s macro trend trade which, in essence, was simply a multi-faceted expression of ever tighter financial conditions in the US predicated on the most aggressive Fed hiking campaign in a generation.

The reversal fortune for the FCI tightening trade (in all its various manifestations) is problematic for the macro fund universe, which was (past tense) enjoying something of a renaissance.

“I would imagine that most readers saw headlines on Friday of a high-profile macro fund having lost huge chunks of their prior 2022 gains due to the sharp Q4-to-date ‘reversal’ shocks,’ and I am seeing other fund letters now confirming the same pain, as it seems increasingly clear that many have struggled mightily to get out of these trades without enormous exit cost,” Nomura’s Charlie McElligott wrote Monday.

The reference to a “high-profile” macro fund was, of course, to Bridgewater. For those who missed it, Bloomberg reported late last week that Pure Alpha was down 13% in Q4 through last month, cutting its YTD gain to just 6% from more than 20% through Q3. Pure Alpha II was down 20% in the two months through November 30, the same linked article said.

Funds probably assumed the Fed wouldn’t “be able to back down from their hawkish stance” given a resilient US economy, a still tight US labor market and strong household and corporate balance sheets, McElligott went on to say. “All in, the view was that the Fed had to ‘stay the course’ and keep advocating for tighter and more restrictive financial conditions.”

Generally speaking, those assumptions held. The labor market is still overheating (as evidenced by November payrolls and the accompanying hot read on wage growth), consumers haven’t stopped spending and the Fed continues to push some version of a narrative that says terminal is at least 5%, and rate cuts aren’t likely at any point in 2023.

And yet, financial conditions have eased materially, in lockstep with the falling dollar and the retreat in long-end US yields. As the overwrought reaction to Powell’s Brookings address made clear, this is a market ready to turn the page and willing to push the issue in that regard even if it means distorting Powell’s message (i.e., markets hearing what they want to hear).

That’s problematic, because, as Charlie put it Monday, it can mean “short-term, tactical, sentiment- and positioning- dynamics supersede long-term, structural economic- and macro- views.”

“Despite the hawkish AHE / NFP print Friday, which should have provided ‘hawkish relief’ for FCI tightening trades, the ensuing dollar rally was immediately sold into by trapped USD longs as well as fresh shorts,” he wrote. “The moves have become too large to fight as they push through stops, so it’s just a risk management exercise at this point in order to try to protect any positive PNL you have left.”

Writing in his daily column for the terminal, Bloomberg’s Cameron Crise called Friday’s NFP price action “instructive.” “The failure of both equities and fixed income to sustain losses was telling, and suggests that there were no marginal sellers after the post-payroll gap,” he said. “That, in turn, is consistent with a macro-oriented investor base that is primarily concerned with risk management rather than alpha generation.”

Crise also mentioned Bridgewater’s QTD stumble. The fund “likely ran a lot of the same thematic positions as discretionary macro investors,” he remarked, before suggesting CTAs have lost money too lately given their “correlation with discretionary macro managers this year.”

In that context, it’s worth noting that on Nomura’s model, there’s one USD long holdout left: CTAs (figure below).

“This may surprise some in light of the magnitude of the recent reversal lower in USD, but the Nomura QIS CTA model still has almost exclusive ‘long US Dollar’ expressions, due to the deep ITM nature of USD longs across long-term windows,” McElligott said. Those are the windows where the weighting is.

And yet, it wouldn’t take too much to trigger unwinds. “We are finally nearing levels in key USD crosses where we could see this long USD positioning finally shaken out in what would be huge notional USD selling,” Charlie added.

As the dollar goes, so goes the rest of the FCI tightening trade. Another blast of dollar weakness would amount to an impulse easing, particularly if it were accompanied by a favorable CPI report and a dovish slant on the already dovish “step-down” at the December FOMC meeting.

Those are big “ifs.” And the point here isn’t to make predictions of any kind. Rather, I wanted to mention the Bridgewater story in the context of i) Q4’s FCI trend trade reversal, and ii) year-end performance dynamics.