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I need a dollar

Risk assets had a terrible time early in October. What was all the fuss about? Soft US retail sales data? Hardly. The geopolitical background? Unlikely. Weak numbers out of Germany and a lack of faith in the ECB? Jitteriness at the prospect of the Fed packing up QE? Quite possibly. 

Note that this was a rare period of US dollar weakness: before, every time Germany disappointed or the euro-zone’s inflation reading ticked towards zero, USD/EUR would soar. This time FX and bond markets hinted that Europe’s slowdown might weight on the rest of the world, too. Maybe the Fed would eke out a bit more QE? And maybe that was why investors bought this October dip so spectacularly? 

On the day of the Fed decision, I asked one chief economist if we should expect any surprises. “Only if Yellen is anything other than super-dovish,” he said, clearly sceptical. As it happened, Janet Yellen’s language was indeed less than dovish on employment. Recent market volatility hadn’t fazed the Fed. More remarkably, Yellen’s sternness didn’t faze the risk takers. 

The party really kicked off when the Bank of Japan opened its floodgates two days later. Within a week, Mario Draghi claimed unanimity for his stated plans for the ECB’s balance sheet – which make government-bond purchases look inevitable. It would take a brave, brave soul to bet against the greenback now.

All the time this is about selling euro and yen into US risk assets, investors will be happy. But dollar-strengthening cycles rarely end well – think the early 1980s and mid-1990s. The soaring exchange rate is, of course, a symptom of a shortage of dollars, and euro and yen liquidity simply isn’t the same as dollar liquidity; for all the talk of Asia weaning itself off dollar-funded trade, it remains the engine of global economic activity. 

Where does this end? With fewer dollar pegs to defend, a generalised balance-of-payments crisis in emerging markets probably isn’t on the cards, but some casualties will be big, and there is bound to be spillover. Europe and Japan, with their big trade exposures to Asia, could also suffer. But commodities look especially vulnerable. Gold is already shedding its currency pretensions. Less appreciated is the fact that, as consumption falls, more and more oil is stored ‘in transit’, and as greenbacks are sucked out of the system it will be increasingly tempting to claw some of them back in exchange for the black stuff. That is clearly already happening – but $80/bbl might look like a very good price before 2015 is out.

All of this means that some fierce momentum is building behind a number of market trends for 2015. This would be a marked change from recent conditions and should herald a major turnaround for trend-following macro strategies. The strong-dollar trades should be easy pickings – but when the system starts to exhibit the inevitable strains, their returns could well go parabolic.

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