Last week, I asked the question, “Is risk now under-priced?” concluding that there is a danger of another spike in the dollar if markets return to risk-off mode (potentially as a result of concerns surrounding a second wave). While this clearly shouldn’t be ruled out, there is an increasing number of reasons to be bearish on the greenback, which we will explore this week before taking note of what the market is telling us.

Between early 2018 and the latter stages of 2019, the dollar had been the standout performer in the currency markets, supported by a strong economy, which justified higher interest rates and more than offset the drag of the twin deficits. However, it’s unclear how the US economy will fare on the global spectrum in the wake of COVID, especially with an increase in the number of new cases. The Fed has indicated that it stands ready with additional monetary stimulus if required. Another cut in interest rates or an expansion of the Bank’s balance sheet should have a negative impact on the dollar, especially if other central banks around the world do not follow suit.

Fiscal deficits and debt level are soaring across the globe, but the US is outpacing most governments. As unemployment rises, the deficit will only widen further. This may not be a problem, particularly with borrowing costs so low, if someone is willing to buy the debt. However, there will inevitably come a point where demand starts to dry up and investors demand a higher premium. This would be a big problem for the dollar.

Regular readers will know that we keep a close eye on PPP valuations when thinking about long term risks for a currency. The dollar is currently ~11% overvalued against the euro and ~13% overvalued versus the pound. History tells us that currencies can remain over / undervalued for many years before they return to ‘fair value’ and the current valuations are by no means extreme, but from a multi-year perspective, there is clear justification for holding a long-term bearish view.

What is the market currently telling us?

Bloomberg Poll FX Forecasts

We always take consensus forecasts with a pinch of salt (primarily because they tend to centre around spot rates and downplay the risk of volatility) but it is always interesting to take note of a significant deviation from spot, as we see here. The table above shows a clear bias towards a weaker dollar against both the euro and the pound as we head into 2021.

Speculative EUR Positioning

Source: Bloomberg

As shown in the chart above, positioning in the futures market is heavily skewed in favour of the euro versus the dollar. In fact, the only time in the past twenty years that investors have been more optimistic on the euro / pessimistic on the dollar was briefly during early 2018 (the beginning of the trade war with China).

EURUSD 25 delta Risk Reversal

Source: Bloomberg

The chart above shows the cost of EURUSD puts vs EURUSD calls. If puts are more expensive, it suggests that the market is more concerned about downside risk in EURUSD than the upside. Although we are a long way from the extremities seen over the past fifteen years, calls are currently marginally more expensive than puts, implying that investors are paying a premium to protect against a move higher in EURUSD compared to protecting against a move lower.

Technical Analysis: EURUSD

Source: Bloomberg

The chart above shows that EURUSD has broken the downward trend channel of the past two years. The question now is whether this break is the start of a recovery for the euro / a move lower for the dollar or whether momentum fizzles out and a new range develops between 1.08 and 1.15. Time will tell, but a sustained move back above 1.1500, a key level which has capped rallies since late 2018, would suggest that there is further upside scope in the direction of 1.20 in the months ahead. 

Conclusion

We have long held the view that the dollar would outperform its peers – a bias that has served us very well over the past two years. Whilst there are obvious factors which would trigger a further spike in the dollar (most notably a second wave of COVID-19 across the globe or a faster than expected recovery in the US vs the rest of the world), we find ourselves questioning how much further the dollar can go. It is clear the euro continues to find good support on dips beneath 1.1000 and even sterling now seems to get bought into dips. With this in mind, we find ourselves on the verge of switching to a more bearish stance on the dollar, something we’ll discuss in more detail in next week’s report.

Author: Marc Cogliatti