Why the dollar looks unstoppable

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  • Demand for the dollar is rampant as inflationary pressures lift yields and stagflation worries burnish its haven credentials.
  • Most strategists expect the greenback to be particularly strong against low-interest currencies such as the euro and yen, because their central banks are expected to lag the Fed in raising rates.
  • Futures now imply a 90% chance of a US rate hike by November 2022.

The dollar is poised to reach fresh highs in coming months as an anticipated tapering of Federal Reserve stimulus, seasonal demand and energy-driven instability unleash a wave of bullish bets on the currency.

Evidence of the greenback’s dominance is rampant as inflationary pressures lift yields and stagflation worries burnish its haven credentials. It’s at highs not seen since December 2018 against the yen, while CFTC data shows leveraged funds are the most bullish in over a year. Traders are paying more to hedge against gains than declines - at levels last seen around the pandemic’s first wave - according to options pricing for members of the Bloomberg Dollar Spot Index.

Not even a disappointing September US jobs report derailed the currency, because traders still expect the Fed to start reducing asset purchases this year. In fact, the market read inflationary signals in the report as further evidence that US interest rates would have to rise sooner than later, which would lift yields and the dollar. 

Fed funds futures now imply a 90% chance of a rate hike by November 2022, with the odds essentially a coin flip at the end of July.

Sustained strength in the world’s reserve currency risks triggering a wave of capital flows across markets. That could further sour risk appetite that’s already being pressured as spiking energy prices spur angst about 1970s style stagflation. Sentiment toward the greenback was negative as the year began, leaving investors to recalculate their bets as the greenback pushes higher.

Rabobank’s Jane Foley is among strategists saying the dollar is poised to gain further as yields rise and demand for emerging-market assets remains dulled. Saxobank’s John Hardy thinks the dollar could "make life miserable for the bears in Q4," predicting the market will finally begin to take Fed tapering seriously. 

While the trade may look "overstretched and overcrowded" its still got some way to go yet for these reasons, according to Bloomberg Intelligence’s chief G-10 FX strategist, Audrey Childe-Freeman. "The anyway-it-wins dollar view may dominate for a while longer." 

Lagging peers

Most strategists expect the greenback to be particularly strong against low-interest currencies such as the euro and yen, because their central banks are expected to lag the Fed in raising rates.

"We are getting somewhat close to that tapering narrative in the US, and those other funding currencies are still some considerable distance away," said CIBC's Jeremy Stretch in an interview with Bloomberg TV Monday. "Central banks like the ECB are going to probably be on hold for the next two-three years, so that ultimately favors long dollar positions."

Bets on faster Fed hikes have sent the two-year Treasury yields to their highest level since March 2020, widening their gap to around 101 basis points versus their German counterparts and 44 basis points against Japanese peers. 

That has left analysts chasing the currency and bond moves, with ICE’s Dollar Index and 10-year Treasury yields already above consensus year-end forecasts. 

Ultimate haven?

This year's high for the dollar was set in September, when investors were seeking safety as risk assets were roiled by China’s property-sector turmoil and the combination of slowing global growth and quickening inflation. It could get another lift from demand for protection as an energy crisis continues to rattle markets.

The unprecedented spike in energy prices has also been a key driver of the dollar while hurting the euro, according to Kevin Thozet, a member of the investment committee at Carmignac. He’s been increasing his exposure to the greenback for the past month or so.

"The move is likely linked to what’s happening on the commodity side," he said. "Because the US is self-sufficient on that front, and it’s not the same for the euro area."

The euro-dollar pair has been hovering near lows not seen since July 2020, in part due to the dollar’s increasing strength. Speculators have been unwinding long euro bets since the second half of last year, with positions last week turning the most bearish since March 2020. 

Weakening global growth forecasts combined with climbing inflation makes the US currency an even more attractive wager, JPMorgan’s Meera Chandan wrote in a research note Friday. "The backdrop lends itself to owning dollars on a broad basis, not only vs. higher beta currencies that are typically sensitive to growth, but also relative to other defensive currencies like the yen."

The dollar as a haven is a relatively new phenomenon. When times are tough globally, FX traders have historically looked to the Japanese yen and Swiss franc for stability. But with unbeatable liquidity and a widening yield advantage, the US currency has become an attractive venue for storing value during market turmoil, according to CIBC’s Stretch.

"Investors are looking for a certain degree of safety and security, and I think in that context from the FX perspective does lead us back toward that broader dollar narrative," Stretch said. One-month risk reversals for the dollar-yen pair are in touching distance of turning bearish on the Japanese currency - the first time since June this year.  

Fed policy will likely give the dollar an advantage over the next few months, and not just against traditional havens, according to Mazen Issa, senior FX strategist at TD Securities. The greenback also tends to benefit from a seasonal advantage against other G-10 currencies in the fourth quarter, he said.

"Is the dollar a safe haven? Against the backdrop, perhaps so. But, I think it’s more about the shift in monetary policy risks," Issa said. "It just seems like you need to respect the dollar now."

- With assistance from Cormac Mullen and Philip Sanders 

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