Hedge Funds at Risk as Fed Dollar Focus Threatens Bull BetsBy
Brainard likens greenback gains to 200 basis points of hikes
Currency has risen 20% since 2014 using broadest Fed index
Dollar bulls beware: The greenback is very much on the Federal Reserve’s radar.
While the currency has dropped against the euro and yen in 2016, it’s barely declined judging by the Fed’s broadest measure of the dollar versus U.S. trading partners. By that index, it’s up 20 percent since the start of 2014. Governor Lael Brainard, in the last comments before the quiet period leading up to Wednesday’s policy decision, said the greenback’s rally may be having the same economic impact as raising the federal funds rate by about two percentage points.
For traders in the $5.1 trillion-a-day currency market, the challenge is to determine whether the dollar is too strong for policy makers to tighten again following liftoff from near zero in December. Hedge funds and other speculators are among those with the most at risk. They’ve been betting on dollar gains since May, and those wagers, amounting to about $8 billion, may falter if officials forgo tightening this year out of concern a dollar rebound would undermine the world’s largest economy.
“The exchange rate has no doubt taken a more important role in monetary policy,” said Paresh Upadhyaya, director of currency strategy in Boston at Pioneer Investments, which oversees about $236 billion. “It has made me very cautious on a much stronger U.S. dollar rally.”
The consensus on Wall Street is for a quarter-point Fed hike by year-end, to a range of 0.5 percent to 0.75 percent, and modest dollar gains. A U.S. economic recovery and expectations that the Fed would tighten while other central banks added stimulus helped drive greenback strength the past few years. Higher rates tend to draw investors to a currency. The dollar will appreciate about 1.2 percent to $1.10 per euro by year-end, and about 3 percent to 104 yen, according to the median forecast in Bloomberg surveys.
The greenback was at about $1.1150 per euro and 100.90 yen as of about 8:15 a.m. in New York.
Fluctuating views on divergence have caused the pace of currency swings to rise by about 50 percent from two years ago, according to a JPMorgan Chase & Co. index. The volatility compounds the woes of U.S. companies grappling with the challenge of hedging against the dollar’s appreciation, which erodes the value of revenue abroad. 3M Co., the maker of Post-it notes, cut its outlook in July for sales growth after the dollar weighed on second-quarter earnings.
For traders betting on divergence, Wednesday is presenting a crucial test.
The Bank of Japan in its policy decision shifted the focus of its monetary stimulus away from a rigid target for expanding the supply of money, to targeting the yield curve. The Fed makes its announcement at 2 p.m. New York time. Futures imply barely a one-in-five chance of a hike, assuming the effective fed funds rate trades at the middle of the new target range. Officials will also release quarterly forecasts, including for the fed funds target, in a chart dubbed the dot plot.
Policy makers may not be as fixated on the dollar as last year, when triggers such as China’s surprise currency devaluation in August led the Fed to pay even more attention to how the health of the global economy translated to exchange rates.
Minutes from the September 2015 Fed meeting showed officials referred to the greenback 24 times, double the frequency of the previous gathering in July. Mentions of the dollar have run in the single-digits the past few meetings of 2016.
Brainard’s remarks on Sept. 12 were part of a speech in which she said prudence is warranted as boosting borrowing costs poses risks. The remarks signal the dollar is still an important part of the debate for her. She noted research showing changing sentiment on U.S. monetary policy relative to that abroad is generating currency swings that are “several times bigger” than years ago. Chair Janet Yellen said last month the appreciation was restraining exports.
The prospect of a dollar rally on rate-hike bets also poses a headache because an appreciating currency reduces import prices, working against the central bank’s goal of boosting inflation.
“The Fed has to look at the relationship between global rate divergence and exchange rates,” said Laurence Meyer, a former Fed governor and now president of LH Meyer Inc., an analysis firm in Washington. “Whatever you think are the empirical relationships, you can take that into account in your forecasts and where your ‘dots’ are,” said Meyer, who predicts the Fed will likely stand pat this week and hike in December.
The Bloomberg Dollar Spot Index, which tracks the greenback against 10 major peers, is down almost 4 percent this year. The Fed’s broad index measures the dollar against more than two-dozen currencies. The Bloomberg index pared its 2016 drop last week as data on U.S. consumer prices showed inflation was moving closer to the Fed’s 2 percent goal. The Fed’s preferred gauge of inflation has been below that target since 2012.
Hedge funds and other money managers held net bets wagering on dollar strength versus eight major currencies in the latest week, Commodity Futures Trading Commission show. The group was net bearish as recently as May.
Steven Englander, global head of Group-of-10 currency strategy in New York at Citigroup Inc., the world’s biggest foreign-exchange trader, sees the Fed paying more attention to global markets. However, in his view the economy is weathering the dollar’s appreciation.
“There is a lot of discussion of the sensitivity of the U.S. economy and U.S. asset markets to foreign developments,” he said. “Everyone has a different way of approaching this. Brainard is very sensitive to what is happening abroad.”