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Why A Dollar Rebound May Be Imminent Even As Crash Insurance Costs Hit Nosebleed Levels

Is the bottom in for the dollar yet?

After hitting a 14 month low, the Bloomberg Dollar Index saw a modest gain of 0.1% as markets awaited this week’s FOMC meeting and kept a wary eye on Capitol Hill hearings which involve close members of the Trump administration. Quoted by Bloomberg, traders described flows as modest amid the elevated event risk we laid out earlier this morning. Besides another potential surprise from the suddenly dovish Fed, traders were keeping a weary eye on Capitol Hill hearings Monday and Wednesday that include Jared Kushner, Donald Jr and Paul Manafort, and what these could mean for Trump's fiscal agenda. At the same time, the Fed is expected to keep rates and policies on hold, though it may elaborate on balance-sheet reduction or the timing of any future rate increases.

To be sure, negative sentiment against the dollar has been pervasive, and as we noted yesterday when looking at the latest CFTC Commitment of Traders update, net specs are now the most short they have been the USD doing back to 2013.

Worried that the decline in the USD may continue, Bloomberg writes this morning that FX traders are now paying the most in since October 2009 for options to protect against an extreme decline in the dollar against the euro over a six-month period: the 10-delta risk reversal, an indication of trader bias in the options market, reflects expectations that any move in the euro would be dramatic.

Additionally, traders are also piling into options contracts in anticipation of big moves in the euro-dollar exchange rate, eyeing the critical resistance level, the $1.1714 high from August 2015. According to Bloomberg calculations, traders bought more than $6 billion in options to sell dollars and buy euros on July 20 and 21, and an additional $3 billion to sell the greenback against the yen, according to DTCC data.

However, a more nuanced look at who is trading the dollar, suggests that the plunge may be ending.

Citi's FX quant desk writes that as real money became strong net sellers of USD, hedge funds became aggressive net buyers for the first time in months "a sharp increase in conviction over previous weeks." Looking at the 1-month cumulative investor flow, shown on the right hand side, this divergence became clear in the ladder half of last week, following the EURUSD reaction to the ECB meeting.

Some more context: USD is currently the second largest short position among real money investors in G10 overall, with both 1-week and 4-week net flow decidedly negative. So far in July, real money clients have been net sellers on 80% of days, a continuation of the long-term bearish run for the greenback.

On the other side of the real money, hedge funds were net buyers of USD last week, mostly due to a large amount of buying in response to USD depreciation in the immediate aftermath of the ECB meeting last week. Hedge fund flow on the day of the meeting was sharply against the EURUSD move, with hedge funds strong buyers of USD and sellers of EUR on the day.  Looking at current 4w aggregated flow, leveraged investors are likely long USD and short EUR, a sharp contrast from the significantly short real money positioning. 

According to Citi, "this divergence between leveraged and real money flow opens up the possibility that real money will follow, and we could see USD appreciation in the coming weeks."

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Finally, here is Bloomberg commentator Marc Cudmore, predicting that a Dollar bounce is imminent.

It’s the question on every trader’s lips because the answer influences the price of almost all other financial assets: When is the dollar bouncing? I see it making a short-term base this week.

Financial assets rarely sustain a straight line move even when it appears fundamentally justified. And dollar depreciation is certainly logical.

 

However, the last leg down has mainly been driven by the latest political turmoil and that’s a problem for bears. Apart from the macro consequences of Trump’s fiscal program being priced out (which already happened months ago), the direct impact of U.S. politics on markets this year has only ever been fleeting. So the latest ructions change little apart from negative headlines.

 

Euro strength has facilitated the broader dollar depreciation trade but that theme is also looking vulnerable in the short-term. Consensus has suddenly turned bullish on the euro at a time when the ECB just sounded unexpectedly dovish and EUR/USD is facing multi-year resistance at $1.1714.

 

For the Bloomberg Dollar Spot Index, both daily and weekly RSIs are looking stretched on the downside as we enter a week with an obvious potential catalyst in the FOMC meeting. Profit-taking will surely be too tempting especially as we get deeper into summer holiday territory.

 

A bounce of a couple of percent won’t derail the long-term macro downtrend that started in January. The U.S. still has a current-account deficit combined with a large debt pile that’s backed by negative real yields. And the currency remains expensive based on PPP metrics.

 

But those are long-term structural issues. For the next couple of weeks, the vulnerable side will be for dollar strength.