FX Dashboard: Speculative Long Dollar Positions Highest Since 2019

Ahead of the critical FOMC statement and updated projections to be released tomorrow, the US dollar has continued to be volatile. With inflation rising to its highest in four decades, the focus will be on whether the Fed announces an accelerated end to bond tapering and whether the dot plot has more than one rate hike for 2022 as the median forecast or not.

In a recent note, Implications of Higher Dollar Volatility for EM Currencies, I espoused the following views:

• The dollar should remain volatile until the market prices in the rates curve the potential monetary tightening path for the Fed with a fair degree of certainty based on incoming data.
• After appreciating over 2% in the past month, the bias is for the dollar to strengthen further in the near term. Indeed, I expect the dollar to be at one of the two ends of the dollar smile based on which of the following scenarios plays out:
  • In the first scenario, the Omicron variant, which has proven to be more contagious than even the Delta variant, leads to more widespread restrictions as has already been happening in some parts of the world. Such a scenario would lead to a deeper correction in US equities and broad risk aversion, leading to a demand for safe-haven assets like the dollar.
  • In the second scenario, the Omicron variant turns out to be less deadly even if it is contagious. If so, in the absence of growth risks, expectations for more aggressive monetary tightening in the US than otherwise should get priced in the curve, leading to dollar strengthening.

The dollar strengthening may not last given that the currency is quite expensive in real effective exchange rate (REER) terms. In the near term though, the dollar is likely to act as a headwind for emerging market currencies, given their high negative correlation particularly this year (see the chart below).

Data Source: Refinitiv

One factor that has turned against the dollar is positioning. Specifically, long speculative dollar positioning has turned heavy: based on CFTC futures data, at USD 20bn it is the highest since 2019 (see the chart below). As I discussed in a note in April – Short Dollar Positions Have Cleaned Up, the positioning itself is not a negative for the dollar because:

• Although the long dollar position is the heaviest in over 2 years, it is minuscule in comparison with the daily FX turnover of USD 6.6tn of which the dollar is on one side of 88% of the trades, according to the last BIS Triennial Central Bank Survey.
• While at first glance the dollar appears to be highly correlated with the positioning data (see chart below), looking deeper shows that, if anything, positions tend to follow the dollar rather than the other way around. The correlation of weekly changes in positions with weekly dollar moves is close to 0% over the past 4 years. However, if we lag the weekly changes in positions by 2 weeks, the correlation jumps to 30%, which is not very high but indicates that the causality is the dollar driving positions.

Nevertheless, if dollar positions are heavy one way or another, then they can exacerbate the dollar moves. In that sense, if and when the dollar does start weakening, then the unwinding of the speculative long positions can exacerbate the dollar correction. Whenever that happens, the environment should turn very supportive for emerging market currencies. It is thus important to track the dollar for turning points to target long exposures to EM currencies ahead of the move.

Data Source: Refinitiv, CFTC

Best Longs / Best Shorts

• To the list of underperformers based on my models in the attached FX Dashboard pdf, I added South African rand (ZAR) and Indian rupee (INR) as their z-scores crossed 1 but removed Chilean peso (CLP) as its z-score receded.
• The list already had Hungarian forint against the euro (EURHUF) on it.
• The list of outperformers stayed unchanged with Chinese renminbi (CNY) and Israeli shekel (ILS) on it.

Best Crosses

• The list of the preferred relative-value trades based on my models changed to Long South African rand (ZAR) vs Short ILS or CNY or Colombian peso (COP) or Peruvian sol (PEN).
• The 3m expected returns for these pairs are in the range of 10-13% (not annualized), assuming mean reversion.