In our previous take on the US dollar in early February, we wrote that the currency was set to remain weak. At the time, ex-US growth was accelerating, while speculator sentiment was only mildly bearish. While dollar bulls have argued that rate hikes should help the currency, we wrote that expectations for monetary tightening were rising around the world, limiting the impact from the Fed’s actions. Since that time, the dollar has traded sideways in a narrow range. Looking at the US dollar index (a weighted measure of the currency against its largest peers), the dollar was trading around 90 and remains at similar levels today.

As dollar trades sideways, outlook looking increasingly neutral

Since our previous commentary, ex-US growth has decelerated significantly, particularly in the Eurozone. Turning to sentiment, speculator net short positions in the US dollar are now 50% larger relative to last February. As growth slows while speculators chase momentum in the euro, the ongoing rally in assets negatively correlated with the US dollar is looking riskier. This is particularly true for the euro, which we covered in greater detail in a recent commentary. An additional concern is the Hong Kong dollar, which may develop into a significant risk in a larger downturn.

While the buck has been selling off for the last 15 months, we argue that investors should prepare for a stronger dollar. Over the coming weeks, we expect to upgrade our medium-term outlook on the dollar to neutral (from bearish today) as a result.

As ex-US growth deteriorates, USD liquidity pump running dry

As the world’s reserve currency, the US dollar trades inversely to global growth expectations. This is because the dollar is the most popular liability currency, meaning it is borrowed heavily for cross-border investments. When optimism for global growth is running high, investors tap US capital markets in order to finance international investments. While borrowing dollars is relatively more expensive than currencies with negative interest rates (such as the euro), the buck remains the most popular option given the significant scale and liquidity offered via US capital markets. During boom times, more and more dollars chase foreign investments, weakening the currency. When the inevitable downturn strikes, borrowers struggle to repay USD loans, and sell assets in order to raise cash.

While there are few signs of a full-blown global downturn, the slowdown in Eurozone and Asian growth expectations is putting the dollar sell-off on pause for now. Manufacturing PMIs for the Eurozone and Japan, a good barometer for global optimism, is shown below for reference:

PMIs in the Eurozone and Japan now decelerating

(Click on image to enlarge)

Source: Nikkei, Markit, MarketsNow

As can be seen above, growth expectations peaked in early 2018 and are now decelerating. Back in February, manufacturing sentiment in both the Eurozone and Japan was accelerating. Today, the economic cycle has more clearly turned a corner. Recent “hard” data (such as industrial production) is also slowing today, lending further support for declining growth expectations.

The consensus “short dollar” trade getting more crowded

Looking at positioning on US exchanges, speculators remain bearish towards the US dollar. In the chart below, US dollar positioning is calculated as the inverse of positions in EUR, JPY, GBP, CAD, AUD and CHF futures and options contracts.

Shorting the dollar is a consensus trade

(Click on image to enlarge)

Source: CFTC, MarketsNow

As can be seen above, the net short position continues to increase (last seen at -147,490 contracts). Beyond absolute figures, looking at the size of the net position as a proportion of overall interest is a good way to gauge if positioning has become one-sided. As a proportion of total interest, the short position is currently 11% of the total interest.

This suggests that shorting the dollar is once again a consensus trade. In October 2017, the last time speculators were short the dollar to a similar degree, the US dollar index rallied from around 93.50 to 95. While bearish sentiment does not mean a dollar comeback is imminent, there is a growing risk of a short squeeze as the trade gets increasingly crowded.

Problems in China unlikely to be benign

Lastly, China’s currency problems are worth watching closely. As Chinese growth decelerates from its peak last year, problems are cropping up in the country’s financial markets. While the Chinese renminbi has rallied to multi-year highs (USD/CNH is currently trading at its best levels since August 2015), the ongoing weakness of the Hong Kong dollar suggests a different story. The Hong Kong dollar has weakened to the lower end of its trading band (7.85), and has failed to strengthen despite repeated interventions from the Hong Kong Monetary Authority. Over the past few days, the HKMA has directly intervened by purchasing $9.66b HKD ($1.23b USD) in the foreign exchange market.

Most commentary describes the problem in terms of excessive capital parked in Hong Kong. While Hong Kong dollar interest rates should theoretically mirror US rates (as the currency is pegged), Hong Kong dollar interest rates are actually much lower. This creates an incentive for speculators to borrow Hong Kong dollars and invest the proceeds in the US dollar, causing the currency to weaken.

While this may be a plausible explanation, there is a significant risk in the event of a larger downturn. Most Hong Kong mortgages are issued as floating rate instruments tied to local interest rates. While the HKMA has been nudging rates higher in response to the HKD sell-off, raising rates too high will ultimately cause real estate prices to fall sharply, leading to capital flight out of Hong Kong. In this event, Hong Kong’s liquidity situation will transform from a flood into a drought, threatening the 35-year peg.

Beyond the mechanics of the peg, the other significant issue is Hong Kong’s significant banking relationship with China. As described by University of California (San Diego) Associate Professor Victor Shih, Hong Kong has become the primary conduit for Mainland Chinese US dollar borrowing. If Hong Kong experiences significant capital flight, international lenders are likely to curtail lending to the city, in turn cutting off Mainland Chinese borrowers from US dollar financing. If Chinese borrowers struggle to repay their US dollar liabilities, expect financial conditions to tighten and fears of a Chinese currency devaluation to reappear. For now, markets continue to ignore the risks of a Chinese slowdown, as problems in the Hong Kong dollar are seen as relatively arcane and isolated. In the event of a significant downturn, Hong Kong’s woes will have global implications.              

Tailwind to headwind?

All in all, the ongoing sell-off in the US dollar has been a significant boon to investors since 2017. As economic expectations have improved over the past 15 months, the buck has sold off accordingly. In turn, this has led to a significant boom in riskier financial assets such as equities, corporate credit and real estate.

Now that the US dollar is undergoing a phase shift, its future trend is looking decidedly more neutral. Unfortunately this means the “easy” gains of 2017 are unlikely to repeat this year. In the words of Warren Buffett “only when the tide goes out do you discover who's been swimming naked.” If the dollar starts strengthening, investors need to prepare for a downturn accordingly.