After tumbling more than 12% from early January to early September, the US dollar index, or DXY, has staged a recovery in recent months.
It’s risen close to 4% from the nadir struck on September 8, boosted by renewed hopes for US tax reforms, profit-taking among speculators and increased confidence that the US Fed will continue to lift interest rates.
To George Saravelos, currency strategist at Deutsche Bank, it’s now time for investors to take profit on US dollar longs.
“We turned tactically positive on the dollar versus the EUR, JPY and AUD back in September but now see most dollar catalysts as behind us,” Saravelos says.
“First, the dollar has rallied 4% from its lows which is very close to average bounce-backs in dollar bear markets,” he added, pointing to the table below.
“Second, the market was pricing nothing for the Fed back in September but a year-end rate hike is now considered a done deal and terminal rate pricing — the key medium-term dollar driver — has moved back to the middle point of its historical range.
“Third, the majority of positive news around US tax reform is behind us with the $1.5 trillion budget instruction having passed Congress and the political cycle now moving on to the much more difficult part of debating the detail of tax reform. Passage of a final tax bill will now be at risk of material delays.”
Outside of US-specific factors, Saravelos says there’s also few European catalysts left this year to help dictate direction, noting the near-term policy outlook from the ECB is now widely known while political concerns surrounding Catalonia are easing.
And while he admits US bond yields and dollar tend to rally in the final three months of the year, something that from a historical perspective goes against his call, Saravelos says the risk this year is that markets stay incredibly choppy.
“With a lack of identifiable macro catalysts into year-end, what is more concerning to us is the potential for a self-fulfilling Value-at-Risk (VaR) shock triggered by price action and year-end profit preservation,” he says.
“Positioning in fixed income and currency (FIC) markets is very light, so equities is the space to watch for that.”
Saravelos points out that short positioning in VIX futures — an indication on future volatility in US stocks looking one month ahead — remains near the highest levels on record. At the same time, the actual index remains near the lowest levels on record.
Any lift in volatility, especially with markets so short, could beget even greater levels of volatility, in other words.