Dollar Shorts Cut as Traders Brace for Hawkish Fed Surprise

Investors are trimming bets against the dollar ahead of the Federal Reserve decision Wednesday over fears that a hawkish policy tilt is being underpriced, leaving bears to once again wrestle with a resilient greenback.

The Bloomberg Dollar Spot Index traded near the highest level in two weeks. Meanwhile, risk reversals -- which measure the balance between put and call options -- indicate that sentiment is the most bullish since April.

Should Chairman Jerome Powell start making noise about reining in inflation on Wednesday, Deutsche Bank AG chief international strategist Alan Ruskin recommends investors take bullish positions on the greenback versus the Canadian dollar and the Japanese yen. Canadian Imperial Bank of Commerce’s Bipan Rai, on the other hand, favors short-dated dollar call options against the euro and loonie ahead of the decision.

Dollar Shorts Cut as Traders Brace for Hawkish Fed Surprise

The decision comes at a delicate time for financial markets, which have largely accepted reassurances from central banks in the U.S. to Europe and the U.K. that the acceleration in price pressures will likely be transitory. Still, with inflation and economic growth accelerating, Fed officials may consider moving up a discussion on scaling back monetary stimulus and penciling in a first interest-rate hike as soon as 2023.

Tracking Yields

Last week, traders pared greenback short positions as Treasury yields plunged, a counter-intuitive move that helped fuel a jump in the currency. It’s now back to tracking yields, which are marginally higher, as markets fixate on any clues from the Fed about asset tapering or inflation expectations.

Dollar Shorts Cut as Traders Brace for Hawkish Fed Surprise

“With risks to U.S. yields weighted to the upside, the dollar is likely to benefit from any bond-market repricing of the Fed and inflation outlooks,” said Win Thin, a strategist at Brown Brothers Harriman.

He expects the Fed to keep its current rate settings unchanged, but with a more upbeat economic outlook and higher interest-rate predictions by officials. There is also the prospect they will talk about the process for dialing back the pace of asset purchases.

‘Raging’ Debate

The dollar has had its ups and downs so far in 2021 and is currently about 0.4% stronger than where it started the year. Wall Street remains divided on its direction, and a clear signal from the Fed has the potential to once again roil speculators, who remain mostly bearish, according to the latest Commodity Futures Trading Commission data.

“There is certainly some push and pull amongst investors between those that believe the message around inflation being transitory, versus those that think the Fed has it wrong and will need to shift hawkish more quickly,” said Kristen Macleod, co-head of global foreign-exchange sales at Barclays Plc.

“For those investors holding onto their USD shorts despite the price action, many have hedged some of that exposure by purchasing USD calls,” to cover Wednesday’s Fed decision, she said.

While Societe General strategist Kit Juckes expects Powell to deliver enough of a dovish message to keep a lid on the dollar and yields, it’s not guaranteed to settle the question of whether inflation is temporary. “A clear dovish message would keep the inflation debate raging,” he said.

It’s not just in the U.S. where speculation over prices is intensifying. In the U.K., data on Wednesday showed inflation accelerated more than economists forecast in May and above the Bank of England’s 2% target, sending the pound up by as much as 0.3% against the dollar. If the Fed is neutral or dovish, sterling could gain further, according to Jordan Rochester, a strategist at Nomura International Plc.

Charts Cheering

Chart trackers see more room for optimism on the dollar. Technicals on the Bloomberg Dollar Spot index have been improving after the index formed a bullish hammer pattern earlier this month, while its 21-day moving average is ascending.

The gauge is also pressing against its upper Bollinger for the fourth session in a row, the longest such streak since early March. The Bloomberg dollar gauge rose as much as 0.3% on Tuesday to touch the highest since June 4.

Dollar Shorts Cut as Traders Brace for Hawkish Fed Surprise

JPMorgan Chase & Co. strategist Daniel Hui believes the dollar will ultimately head higher after the Fed meeting, but perhaps not immediately, with the currency potentially lingering in the summer doldrums awhile even if tapering discussions begin.

“The actual change in policy settings is still unlikely to happen for at least six months, given Powell’s promise for ‘guidance well in advance,’” he wrote in a report Tuesday.

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