Traders Bent on Bludgeoning Dollar Ignore Bond Market Signals

Updated on
  • Treasury-Bund yield gap widens to most in two decades
  • Change in long-standing convention puts fundamentals at fore

Oanda's Innes Says Lack of Inflation Weighs on Dollar

Even higher yields aren’t rushing to the aid of the currency market’s favorite whipping boy.

The dollar is ending the year down about 12 percent against the euro, even after three interest-rate increases by the Federal Reserve took the spread between two-year U.S. and German note yields to near its widest in nearly two decades. Traders who have long taken their cue from interest rates are focusing instead on a macro outlook that shows Europe’s economy revving into high gear as the U.S. cycle begins to age.

It may take a lot more persuasion for the market to stop beating up the U.S. currency. The euro is seen extending its run against the dollar next year even though the European Central Bank isn’t expected to abandon near-zero rates until 2019.

“The hurdle for further sustained dollar strength will increase,” said Lee Hardman, a currency strategist at MUFG in London. “The Fed would need to embark on a more rapid pace of rate hikes to more seriously challenge our bearish outlook for the U.S. dollar.”

A hawkish Fed and dovish ECB aren’t making much impression. The euro only briefly wobbled after U.S. policy makers on Dec. 13 reiterated their outlook for three U.S. rate hikes in 2018.

“This year we can make a very clear case that the Fed has been raising rates and the ECB has been adding to quantitative easing and the interest rate differentials favor the U.S.,” said Alessio de Longis, a New York-based money manager at OppenheimerFunds Inc., which oversees more than $246 billion in assets under management globally. “Nonetheless the euro has appreciated. The relationship between currencies and interest rate differentials has been very weak.”

Still, investors toiling to meet return targets in an era where the pool of bonds with sub-zero yields is $8.5 trillion, according to Bloomberg Barclays Global Indexes, may eventually decide the extra 250 basis points they can get from Treasuries is enough of an enticement to buy dollar assets.

For now, fundamentals are exerting a bigger pull. After a decade being stuck in low gear trying to keep deflation at bay, the euro zone is poised for its strongest annual expansion in a decade.

“The euro has been following a re-rating of sentiment around the European continent, positive sentiment around the European political and growth environment,” de Longis said.

The rise in the spread differential was associated with bearish bets against the single currency a year ago, but now the reverse is true. In the futures market, long positions from hedge funds and speculators outnumbered shorts by about 86,000 in the week ended Dec. 19, according to data from the U.S. Commodity Futures Trading Commission. At the end of 2016, the position was net short almost 70,000 contracts.

Interest-rate differentials might turn out to be lose-lose for the dollar. While traders ignored the gap widening in the dollar’s favor this year, they may use it as excuse to sell the dollar when the spread shrinks as the ECB follows the Fed in tightening policy.

It “should reduce the attractiveness of the dollar versus the euro on a carry basis,” said Bastien Drut, the strategist at Amundi Asset Management, Europe’s largest manager which runs 1.4 trillion euros ($1.7 trillion) of assets. Meanwhile, policy normalization will unleash flows into European equities, offering the euro “an additional tailwind,” he said.

— With assistance by Benjamin Purvis

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