Dollar Suffers as Reflation Trade Transforms Losers Into Winners

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The $5.3-trillion-a-day foreign-exchange market has a new buzzword: reflation.

The threat of deflation weighed down the euro, along with the currencies of Norway, Sweden and Canada, for much of the last year. In the past month, those currencies have been among the top performers as the outlook for their nations brightened at the same time that the dollar -- hurt by an uneven U.S. expansion -- tumbled to its biggest loss since 2011.

Investors are becoming more optimistic about some of last year’s worst performers on signs that central-bank stimulus outside the U.S. is finally helping to generate sustainable economic growth. As oil rebounds, too, traders are unwinding popular bets that had become known as the deflation trade -- positions that benefited the dollar as the U.S. economy looked better than much of the world’s.

“Reflation is a new theme that people are trying to understand now, because we have been fighting the opposite for years,” said Yvette Klevan, a fixed-income manager in New York at Lazard Asset Management, which oversees $199 billion. “This could bode for a weaker U.S. dollar across the board.”

Hedge funds and other large speculators who were betting on a stronger dollar are now rushing for the exit. Net-long positions on further dollar gains were trimmed for a sixth consecutive week, Commodity Futures Trading Commission data show. They had climbed to a record in January.

Inflation Catalysts

While inflation rates across major economies remain well below central-bank targets, prices have stopped dropping for all the Group-of-10 nations, except for the U.S. and Switzerland. The currencies of both had previously served as refuges.

Currencies in the euro zone got a boost from April 29 data showing the broadest measure of money supply in the region expanded the most in five years, suggesting inflation will accelerate. Oil has climbed about 40 percent from its lows in January to back above $60 a barrel, boosting expectations for consumer-price increases and improving trade balances for commodity-producing nations such as Norway and Canada.

The krone rallied 7 percent against the dollar in the past month, the best performer among the 31 major currencies. The top 10 include the euro, Swedish krona, Russian ruble and Colombian peso, which have all locked in at least 4 percent gains.

‘Powerful Reversal’

Policy makers worldwide share investors’ optimism. Norway’s central bank refrained from cutting rates on May 7, walking back from its previous prediction of a severe slowdown. European Central Bank Executive Board member Yves Mersch said the region has left behind the risk of deflation, while Bank of Canada Governor Stephen Poloz said inflation will meet his target sooner than expected.

“It’s a powerful reversal in a short space of time,” Mike Moran, a senior strategist in New York at Standard Chartered Plc, said by phone.

Global bond markets have lost about $400 billion in the past two weeks as investors ponder the end of a six-year rally that sent yields to record lows.

Traders now anticipate average annual inflation of 1.79 percent for the next five years in the euro zone, up from 1.48 percent in January, according to the ECB’s preferred measure of investors’ outlook for long-term price increases, the five-year, five-year inflation swap rate.

Dollar Decline

Even though the outlook for inflation in the U.S. is picking up, too, the greenback has been suffering. The Bloomberg Dollar Spot Index fell 3 percent in April, snapping nine consecutive months of gains. A bond-market gauge the Federal Reserve follows has climbed to 2.03 percent from 1.83 percent at the end of March.

While the dollar may become the ultimate beneficiary of reflation -- when the American economy eventually regains momentum and the Fed raises borrowing costs -- the best bets right now are some emerging-market countries, particularly in Asia, according to Paresh Upadhyaya, director of currency strategy at Pioneer Investment Inc. in Boston.

“There are clear signs of deflation diminishing quite a bit, you can start to see different trades coming around,” Upadhyaya said. Buying the Indian rupee and Mexico’s peso against the yen are good alternatives, he said.

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