One of 2021’s Most-Hyped Calls Risks Backfiring on Dollar Bears

A sense of unease is gathering around one of Wall Street’s most emphatic year-end bets.

Goldman Sachs Group Inc. sees plenty of room to wager against the dollar, Morgan Stanley’s chief investment officer expects a 10% tumble, and Citigroup Inc. sees a slide of as much as 20% in 2021. But the endorsement of finance’s biggest hitters has heavily skewed the market toward dollar losses. That’s prompting a brave few to warn of a painful unwind if the U.S. currency proves more resilient than forecast.

One of 2021’s Most-Hyped Calls Risks Backfiring on Dollar Bears

Dollar shorts are now among the month’s most crowded trades, second only to tech-stock wagers, according to Bank of America Corp. It’s easy to see why: trillions in potential spending is set to drive up the deficit, the Federal Reserve has all but removed Treasuries’ yield advantage by cutting rates to near zero, and vaccine progress is spurring demand for riskier assets over the dollar. Yet the prospects for U.S. growth as a result of those actions may be just what’s needed to lure investors back to American assets.

“The keys to a dollar turnaround are controlling the virus and more stimulus,” said Brown Brothers Harriman’s Win Thin. If both are accomplished, the dollar will start to “carve out a bottom” after the first quarter.

Going Short

It wouldn’t be the first time that a popular year-end trade quickly reversed, or even the first time that calls for dollar weakness have backfired. The imminent demise of the currency’s multiyear bull cycle was also seen at the end of 2017 and 2018, only for the currency to rally through that first prognostication of doom, and slip a little less than 1% through the second.

Now, with the U.S. starting to vaccinate health-care workers and Congress taking another swing at agreeing on a new package of aid, some of the dollar’s biggest hurdles are waning. Even Fed Chair Jerome Powell, who’s previously emphasized that the U.S. isn’t “thinking about thinking about raising rates,” painted a slightly rosier picture of the U.S. economy heading into next year after the central bank’s meeting on Wednesday.

The Bloomberg Dollar Spot Index, which tracks the greenback’s performance against 10 currencies, dropped as much as 0.5% Thursday to the lowest since April 2018. It is already on track for its worst year since 2017, after declining during seven of the last eight months.

Still, that hasn’t stopped bears from loading up on bets that the currency will fall even further. Wagers against the dollar have climbed steadily over the last month, and speculators are now near the shortest they’ve been in more than two years, Commodity Futures Trading Commission data show.

“There is risk to the market being too one-sided,” said Jane Foley, Rabobank’s head of FX strategy. “It could be that the consensus is misplaced with respect to Fed policy or to inflation expectations in the U.S., which could bolster the dollar.”

One of 2021’s Most-Hyped Calls Risks Backfiring on Dollar Bears

Turnaround Signs

While Foley still sees the dollar weakening, there are mounting signs of discomfort about the scale of these positions.

Options traders are paying a premium to hedge against dollar gains versus most major currencies, risk reversals show. A measure of momentum for sellers versus buyers --- the moving average convergence/divergence gauge -- suggests dollar sentiment may be about to pick up. Bank of America’s monthly survey of fund managers shows more worry about crowded dollar shorts than about large bets on Bitcoin, corporate bonds or gold. JPMorgan Chase & Co. also cautioned about betting against the greenback earlier this month.

One of 2021’s Most-Hyped Calls Risks Backfiring on Dollar Bears

The one-sided positioning has encouraged Momtchil Pojarliev, head of currencies at BNP Paribas Asset Management, to take a more nuanced view on the dollar. While he still expects the currency to weaken longer-term, the market imbalance provides an opportunity to pounce on the rally he sees emerging over the next few weeks as riskier assets consolidate the year’s gains.

“I just don’t think there’s a rationale to have a very big dollar depreciation,” he said. “We have a crowded short-dollar position. We have to move back into the other direction just to normalize the market.”

To capitalize, he’s building a big bet on the greenback versus the New Zealand dollar, and plans to buy the euro if the changing tide catches the market off guard.

Smile or Smirk?

These opportunities amid the unease have some traders revisiting a popular model for predicting strength in the U.S. currency, known as the dollar smile. This theory posits that there are two scenarios in which the currency will advance: when risk aversion fuels haven demand, or when U.S. growth outperforms the rest of the world.

While this framework, developed by Stephen Jen, chief executive at Eurizon SLJ Capital Ltd. in the early 2000s, has shown some cracks through the pandemic -- not least when the greenback failed to attract haven seekers as the U.S. struggled to control the virus -- the vaccine rollout and prospect of growth-boosting stimulus under the Biden administration could reaffirm the fundamentals behind both sides of the smile.

Should the greenback rally, “the biggest potential losers are the investors in EM assets,” Jen said. “These currencies are more jittery and easily perturbed.”

And then there’s the prospect that aversion to other currencies -- like the pound and the euro -- push the dollar higher. European and U.K. leaders have yet to seal a post-Brexit pact, and while the European Central Bank hasn’t so far pushed back on the euro’s strength, its patience could wear thin if economic growth takes a hit.

Taken together, the buoys underlying the dollar are enough that PineBridge Investments, which has $112 billion under management, is gearing up for a shift in the second half of 2021.

That’s when “the dollar comes back, regains its footing,” said Michael Kelly, who leads PineBridge’s multi-asset group. “Whether it rises very much, that’s too early to tell, but it will probably stop declining at the very least.”

©2020 Bloomberg L.P.

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