Investors are buying the U.S. dollar again, betting that an increasingly aggressive Federal Reserve and tumult in European politics will help lift the currency as it rebounds following its longest slide in a decade.
The dollar has already bounced roughly 2.9% from its September lows and has risen in five of the past six weeks, powered by gains against the euro, yen and emerging-market currencies. Investors betting against the dollar have also cut back on their positions recently.
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The surge in demand for dollars caught some investors off guard. The Fed took an unexpectedly aggressive tone when officials signaled they expect four rate increases by the end of next year and the Republican tax overhaul plan spurred hopes for faster U.S. growth. Meanwhile, strong showings by antiestablishment parties in Germany and Spain led to renewed concerns about the EU, halting gains in the euro which had sapped the greenback's strength.
The surprise recovery in the currency highlights the unpredictable turns financial markets have taken this year. Expectations that stock prices would remain flat as rising inflation pushed bond yields and the dollar higher have been upended in recent months as stocks soared while yields and the dollar fell. The currency's bounce began at a point where many investors were looking for the euro to extend its gains.
The dollar is still down 6.4% for the year against a basket of 16 other currencies tracked by The Wall Street Journal, and few investors believe that its woes are over. Hedge funds and other money managers were holding a net $17.4 billion in bets against the dollar as of Oct. 3, down from $17.9 billion a week earlier. Bets against the dollar fell for the first time since August, according to data from the Commodity Futures Trading Commission.
But even a temporary reversal in the currency could have widespread implications for asset markets.
A stronger dollar could dent profits for U.S. exporters and multinationals, after rising corporate earnings have helped propel major stock indexes to records. Dollar strength tends to make dollar-denominated commodities more expensive to foreign investors. It could also complicate the plans of many investors who have notched big gains this year by betting on the euro, yen and emerging markets.
"This looks like the beginning of a reversal," said Christopher Stanton, chief investment officer at Sunrise Capital LLC. He bought dollars while betting on declines in the euro, sterling and Australian dollar last month for the fund's shorter-term strategies.
The dollar posted a monthly gain against a basket of major peers tracked by The Wall Street Journal in September, snapping a six-month losing streak. It received a jolt after Fed officials were unexpectedly emphatic about the path of future interest rate increases, following a period of soft inflation data.
Fed officials indicated last month that they're aiming for a third rate increase by the end of this year, and support three more in 2018. That is important, as rising interest rates typically attract yield-seeking investors to a currency in search of higher returns. The dollar had fallen earlier in the year as hopes that the Trump administration could enact pro-growth policies waned and as accelerating expansion in Europe boosted hopes that the European Central Bank might end its EUR60 billion a month in bond purchases.
The lack of sustained inflation isn't restraining the Fed in its efforts to bring its policies into alignment with precrisis standards. "It would be imprudent to keep monetary policy on hold until inflation is back to 2%," Fed Chairwoman Janet Yellen said Sept. 26 in a speech in Cleveland. The measure of inflation preferred by U.S. central bankers held at 1.4% in August.
"We've repriced the Fed," said Edward Al-Hussainy, a strategist at Columbia Threadneedle Investments. The firm has been placing bets on a stronger dollar for the past two months. "Our view is the dollar has been too cheap."
Events in Europe have also supported the dollar, which rallied after German elections offered Chancellor Angela Merkel a more tenuous governing majority than had been forecast, increasing anxiety about the stability of Europe's largest economy. Those concerns were amplified after the Oct. 1 vote in Catalonia, where the Spanish region supported secession in a plebiscite that the central government deemed unconstitutional. This marked a reversal after investors bought the euro following a May election in France where business-friendly centrist Emmanuel Macron defeated right-wing populist Marine Le Pen.
While this dollar bounce may be temporary, and could end with the next piece of bad data or dovish Fed comment, these rebounds can also last many months, making their impact felt on corporate balance sheets and affecting global fund flows.
Currency investors had favored the euro over the dollar on the basis of expectations that the eurozone, with its surprisingly strong growth, offered greater potential for interest-rate increases than the U.S. Money managers, having looked askance at the Fed's relatively modest expectations for a long-term interest rate of about 3%, were looking to the ECB to do more.
The increase in political risk is hurting some of the optimism surrounding Europe. After the Catalan vote, the bond market responded to the upturn in political risk by widening the gap between yields on 10-year debt issued by Germany and Spain to 1.31 percentage points from 1.13, the most since May, according to Tradeweb. Greater differences between the yields on bonds issued by Germany and other European countries suggests higher investor concern, as the largest and strongest economy in the region tends to serve as its benchmark for risk.
The dollar is "not a one-way trade anymore," said Tim Alt, director of rates and currencies at Aviva Investors. The firm is betting the greenback will gain versus currencies of commodity-producing countries such as Australia and New Zealand.
Some investors' hopes that the ECB will tighten more aggressively than the Fed have also taken some blows lately. The Fed's forecast for three rate increases in 2018 was one more than many traders expected, while the ECB has thrown water on some of the speculation about an end in the near-term to its bond purchases. One concern of officials in Brussels has been the unexpectedly strong appreciation in the currency.
The euro may be facing some temporary obstacles amid a longer-term rally, including concerns about the currency's strength from some ECB officials, gains by antiestablishment political movements and investors who may be looking to book profits before placing new bets, said Paresh Upadhyaya, who manages currencies for Amundi Pioneer Investments. He's using rallies in the dollar to buy more euros.
"There are technical and fundamental reasons why we could see a countertrend of dollar strength, even though over a one- to two-year period the dollar is still weakening," Mr. Upadhyaya said.
Write to Ira Iosebashvili at firstname.lastname@example.org
(END) Dow Jones Newswires
October 09, 2017 08:14 ET (12:14 GMT)