Everyone's a dollar bull as taper makes US currency a top bet

New York

THE US dollar is poised to reach fresh highs in the coming months as an anticipated tapering of Federal Reserve stimulus, seasonal demand and energy-driven instability unleash a wave of bullish bets on the currency.

Evidence of the greenback's dominance is rampant as inflationary pressures lift yields and stagflation worries burnish its haven credentials.

It is at the highest since December 2018 against the yen, while Commodity Futures Trading Commission (CFTC) data shows leveraged funds are the most bullish in over a year.

Traders are paying more to hedge against gains than declines - at levels last seen around the pandemic's first wave - according to options pricing for members of the Bloomberg Dollar Index.

Not even a disappointing September US jobs report derailed the currency, because traders still expect the Fed to start reducing asset purchases this year. In fact, the market read inflationary signals in the report as further evidence that US interest rates would have to rise sooner than later, which would lift yields and the US dollar.

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Fed funds futures now imply a 95 per cent chance of a rate hike by November 2022, with the odds essentially a coin flip at the end of September.

Sustained strength in the world's reserve currency risks triggering a wave of capital flows across markets. That could further sour risk appetite that is already being pressured as spiking energy prices spur angst about 1970s style stagflation.

Sentiment towards the greenback was negative as the year began, leaving investors to recalculate their bets as the greenback pushes higher.

Rabobank's Jane Foley is among strategists saying the US dollar is poised to gain further as yields rise and demand for emerging-market assets remains dulled. Saxobank's John Hardy thinks the US dollar could "make life miserable for the bears in Q4", predicting the market will finally begin to take Fed tapering seriously.

Most strategists expect the greenback to be particularly strong against low-interest currencies such as the euro and yen, because their central banks are expected to lag the Fed in raising rates.

"We are getting somewhat close to that tapering narrative in the US, and those other funding currencies are still some considerable distance away," said CIBC's Jeremy Stretch in an interview with Bloomberg TV on Monday (Oct 11). "Central banks like the ECB (European Central Bank) are going to probably be on hold for the next 2-3 years, so that ultimately favours long dollar positions."

US 2-year Treasury bonds currently yield about 100 basis points more than their European counterparts and 45 more than Japanese debt. For 10-year bonds, the yield difference is 173 basis points for the euro region and 152 for Japan.

That has left analysts chasing the currency and bond moves, with ICE's Dollar Index and 10-year Treasury yields already above consensus year-end forecasts.

This year's high for the US dollar was set in September, when investors were seeking safety as risk assets were roiled by China's property-sector turmoil and the combination of slowing global growth and quickening inflation.

It could get another lift from demand for protection as an energy crisis continues to rattle markets. The unprecedented spike in energy prices has also been a key driver of the US dollar while hurting the euro, said Kevin Thozet, a member of the investment committee at Carmignac.

He has been increasing his exposure to the greenback for the past month or so. "The move is likely linked to what's happening on the commodity side," he said. "Because the US is self-sufficient on that front, and it's not the same for the euro area."

The euro-US dollar pair has been hovering near lows not seen since July 2020, in part due to the greenback's increasing strength. Speculators have been unwinding long euro bets since the second half of last year, with positions last week turning the most negative since March of 2020.

Zooming out, weakening global growth forecasts combined with climbing inflation makes the US currency an even more attractive wager, JPMorgan's Meera Chandan wrote in a research note last Friday (Oct 8). "The backdrop lends itself to owning dollars on a broad basis, not only versus higher beta currencies that are typically sensitive to growth, but also relative to other defensive currencies like JPY (yen)."

The US dollar as a haven is a relatively new phenomenon. When times are tough globally, foreign exchange traders have historically looked to the Japanese yen and Swiss franc for stability.

But with unbeatable liquidity and a widening yield advantage, the US currency has become an attractive venue for storing value during market turmoil, according to CIBC's Stretch. BLOOMBERG