Dollar Rally Has Legs as Fed Divergence Trade Comes Back to Life

  • Goldman Sachs favors dollar against yen on BOJ easing outlook
  • Bank of America says greenback will gain versus pound, Aussie

The dollar’s two-week rally has room to run, with Goldman Sachs Group Inc. citing scope for greenback strength versus the yen, while Bank of America Corp. projects gains against the pound and the Australian dollar.

The Bloomberg Dollar Spot Index posted its first consecutive weekly gains since January after falling to an almost one-year low on May 3. It reached a six-week high Friday after data showed April retail sales increased by the most in a year, adding to the case for the Federal Reserve to raise interest rates this year.

The monetary-policy divergence trade, or betting on greenback gains as the central bank tightens policy while most other major nations ease, faltered early this year with the dollar down about 4 percent. Yet the greenback is still set to benefit as the Fed, albeit at a slower pace than previously expected, will be lifting rates more and at a faster clip than traders foresee, according to Goldman Sachs. Part of the dollar’s weakness have come as easing steps by the European Central Bank and Bank of Japan underwhelmed, yet Japan is likely to show its resolve to boost inflation, Goldman Sachs predicts.

“We still see the big picture as dollar supportive,” analysts led by Robin Brooks, the bank’s chief currency strategist, wrote in a note on Friday. “But the ECB and BOJ are tricky. Ultimately, we have more faith that the BOJ will find ways to surprise on the dovish side.”

New York-based Goldman Sachs predicts the dollar will strengthen to 120 yen in six months and 125 yen in one year.

The Bloomberg Dollar Spot Index, which tracks the currency versus 10 major peers, rose 0.9 percent last week. The greenback gained 0.8 percent to $1.1309 per euro and added 1.4 percent to 108.63 yen.

Less Bearish

The rally led hedge funds and other large speculators to reduce bets on dollar weakness versus eight major currencies. Positions that benefit from losses by the U.S. currency exceeded those that benefit from a rally by a net 37,321 contracts in the week ended May 10, a report from the Commodity Futures Trading Commission showed.

“It’s not a monolithic dollar trade as it was,” said Shaun Osborne, chief foreign-exchange strategist at Bank of Nova Scotia in Toronto. “So you have to be a bit wary of potential underperformers and overachievers. The sort of consensus trades haven’t really worked out."

Goldman Sachs is among banks abandoning calls for the euro to reach parity with the dollar by the end of the year. The bank sees the euro trading at $1.05 in 12 months, up from 95 cents forecast previously.

Bank of America strategists see the next phase of dollar gains less broad-based, given a mix of factors including higher commodity prices and more stable global markets. The best wagers are the dollar against the pound before the U.K.’s referendum next month on its European Union membership as well as owning the greenback versus the Australian dollar, Bank of America’s London-based Athanasios Vamvakidis wrote with a team of strategists in note this month.

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