One of the conventionally accepted reasons for the unprecedented hedge fund underperformance in 2014 was that the vast majority of the “smart money” left 2013 and entered 2014, just as the 10Y looked set to decisively break out above 3%, long equities, expressed primarily via the Nikkei which went nowhere for most of the year until in November the BOJ boosted its QE once more, sending the Nikkei surging but long after most stop losses had been triggered to the downside, and short the 10 Year Treasury. The reason: everyone, and certainly every commission- or CNBC appearance-paid pundit, was convinced that this year is when the long overdue and much delayed global recovery would finally take place, pushing inflation and long-end yields higher. Not only did that not happen but virtually the entire world’s official economic data, except that of the US, has suffered, an unprecedented for the “recovery cycle” slowdown.
Still, that appears to not have made the tiniest impression on hedge funds, who for the second year in a row are not only massively short the 10Y, but in fact as the latest CFTC net spec data shows, are even shorter than they were a year ago, when the 10 Year was trading about 100 bps wider. Worse: as the chart below shows the only time in history when specs were shorter the 10Y was five years ago, in early 2010. What happened then was that the 10Y went from 4% to 2.5% in the span of just a few months, facilitated largely by one of the biggest short squeezes in 10 Year history.
The 10 Year is currently trading at 1.95%: a comparable short squeeze now to that that took place in 2010 would send the 10 Year yield crashing to level where the German Bund is trading now.
Will that happen, and how much more pain can hedge funds absorb before they get a collective tap on the shoulder, we don’t know. We do know, however, that the unprecedented bearish sentiment toward 10Y US Treasuries among the speculative community makes it one of the two most crowded trades going into 2015.
What about the second trade?
For the answer we go back to a post, or rather an image we put up in late September of last year “Summarizing The “Long Dollar Trade” In One Chart.” The trade in question was the long-USD trade, and the “chart” was the following:
If we had to update where this trade has gone in the past 4 months again in just one chart, the result would be the following:
In short: just as hedge funds have nothing but hatred and loathing (and certainly fear) for the 10 Year, they have nothing but admiration, love and the most epic bandwagoning in history when it comes to the US Dollar.
This is how Credit Suisse just summarized what is going on with the USD trade:
In FX, aggregate spec positioning in the USD kicked off 2015 with a bang, rising 2pp to 53% of OI, reaching new multi-year highs.
As the following chart shows,the net spec poisition as a % of open interest has never been higher in the USD in the past 5 years…
… Even as sentiment toward virtually every other currency is plumbing unseen levels
Which brings us to the logical conclusion, that while being short the 10 Year is one of the two most crowded trades as we enter 2015, being long the US Dollar is the other most popular trade among the smart money.
How will this all play out, and will 2015 be a year of double max pain as the TSY short squeeze finally arrives and the USD bandwagon collapses? That too we can not answer as of yet, however, we will recall a very prophetic warning by SocGen’s Michala Marcussen, who back then – long before the complete collapse in crude oil, warned about the strong dollar paradox.
It was as follows:
Recent currency movements have triggered nostalgia of the pre-crisis world when dollar strength was synonymous with a prosperous global economy. Hope today is that a strong dollar will cap US inflation, delay Fed tightening and boost exports to the US. To make an impact on US inflation significant enough to slow the Fed, we estimate, however, that EUR/USD would drop to 1.10, USD/JPY to 120 and USD/CNY to 6.50 to significantly shift Fed expectations. To our minds, moreover, such a scenario would only materialise if the growth gap between the US and the other major economies were to widen further.
Should recent dollar appreciation, moreover, breed complacency amongst policymakers elsewhere, this risk scenario could become a very painful reality. The paradox is thus that a strong dollar tantrum could be a more worrying scenario than a Fed tightening tantrum.
1. Dollar not yet strong enough to delay the Fed
Dollar close to long run average: Recent dollar movements have been sharper-than-expected and several crosses (including EUR/USD, USD/JPY and USD/GBP) are now at levels that we had initially only expected to see early next year. For all the speed of movement, however, the dollar does not yet qualify as “strong”. Trade-weighted, the dollar is still just below the long run average. Moreover, on the type of horizons that matter for economics, dollar appreciation remains modest; the trade weighted dollar is up just 2% year-to-date over the 2013 average. Looking ahead, we expect further dollar gains and by mid-2015, we look for a gain of just over 6% on a full year basis.
US growing well above trend potential: The US economy is on course 3%+ growth rates over the coming quarters, well above the 2.2% at which we estimate trend potential. This week’s numerous data releases, including the key September employment report (we look for +260K on non-farm payrolls) should confirm firm US growth. With each batch of robust data taking the Fed a step closer to the exit, the debate now is just how much dollar appreciation it would take to delay the Fed.
The CNY has appreciated (!) against the US dollar: As a rule of thumb, using the OECD growth model, a 10% appreciation of the trade-weighted dollar cuts 0.5pp from GDP growth and 0.3pp from CPI inflation in the first year after the shock. Two points merit note, however. Firstly, by country, we find that China has tended to exert the most significant influence on US import prices. Since this latest dollar rally began in the early summer, the CNY has been one of the rare currencies to appreciate (!) against the dollar, albeit by a modest 1%. Secondly, we note that the narrowing energy deficit, as the result of the shale revolution, suggests reduced elasticities over time.
Taking account of these points, we find that to significantly delay Fed rate hikes, we would need to see an additional 10% appreciation of the trade weighted dollar relative to our baseline. That would entail EUR/USD at 1.10, USD/JPY at 120 and USD/CNY at 6.50 (and would require other major currencies such as the CAD and MXP to also depreciate significantly). Such a scenario, however, is most likely if growth disappoints materially in the other major economies relative to our baseline scenario. A significantly weaker outlook for the main trading partners of the US would it itself be a cause for the Fed to delay.
2. A worrying trend on growth gaps … and capital flows
Several EM economies set to growth at a slower pace than the US: While the consensus growth outlook for the US has improved further in recent months, the opposite has been true for several other major economies, including the euro area, Japan and China. Moreover, our own forecasts remain generally below consensus with the exception of the US, where we are above. This view underpins our expectation of further dollar appreciation. Today, moreover, several EM economies are growing at a slower pace than the US. This is a notable difference from the pre-crisis era and has several implications. First, this lower global growth configuration is one reason why we believe that elasticities linking currency depreciation to growth may now be lower. The correlation between commodity prices and the dollar has also shifted. Finally, we note that capital flows are now moving in a very different pattern.
Dollar and commodities: The link between the dollar and commodity prices has seen several shifts over time. Already prior to the latest moves in currency markets, commodity prices were trending lower in parallel with Chinese growth forecasts. More recently, it seems that dollar depreciation may have been an additional factor driving prices lower. For commodity importers, this is helpful; for exporters, this marks yet a headwind.
Fed tightening may be a better scenario than a very strong dollar: Pre-crisis, in a simplified summary, the strong dollar can be described as having been driven by a global savings glut (mainly from the official sector in emerging economies) seeking a home in US Treasuries and, at the same time, US investors seeking risky capital abroad to profit from strong EM growth. It is also worth recalling that QE1 drove the dollar stronger and supported risky US assets as Treasuries rallied. QE2, on the other hand, saw dollar depreciation as US investors sought return in higher yielding asset abroad, and notably in emerging economies. As discussed above, we believe that a significant appreciation of the dollar relative to our baseline would be consistent with much weaker growth elsewhere.
In such a scenario, dollar would equate to further capital outflows, placing further pressure on already vulnerable economies. Indeed, a “dollar tantrum” scenario could well prove more painful than a “Fed tightening tantrum”, assuming the later comes with better growth in the rest of the world.