The Hot Macro Trade of 2021 Is Going Bust

Betting on a drop in the dollar was one of the most-popular macro trades heading into 2021. But after a painful start to the year, many are wondering whether they wrote off the greenback too quickly.

The argument was simple: a broad vaccination-led global recovery and a stimulus-fueled expansion of the U.S. deficit would encourage investors to favor assets outside America -- sinking the dollar and extending last year’s 5% plunge. Instead, a relatively successful vaccine rollout in the U.S. and signs that further government spending will do more to boost the domestic economy than weigh it down with debt have traders changing course. That’s buoyed rates, burnished the appeal of American investments, and prompted a rush to buy the currency this year.

Of course, it’s still early days, but markets are waking up to the idea that the U.S. -- or at least its economy -- may once again stand as a shining city on a hill, with “American exceptionalism” cited by Bank of America Corp. as a theme behind more dollar gains and by Morgan Stanley, which is watching for signs of it. Add in those benefits the U.S. reaps from its unique role in the global financial system -- something that allows its currency to perform well both when America is out-growing the world or when everyone is mired in a global crisis -- and the greenback has a shot at defying its doomsayers to finish the year stronger.

“It’s increasingly clear that 2021 U.S. growth will benefit from the monetary and fiscal stimulus that’s in the pipeline, and the scale of fiscal stimulus is going to be orders of magnitude bigger than the fiscal stimulus for the rest of the developed world,” said Ed Al-Hussainy, an interest-rate and currency analyst at Columbia Threadneedle, which oversees $547 billion in assets. “That’s all dollar positive.”

That wasn’t the playbook coming into 2021. Traders who crowded into bets against the dollar late last year faced a difficult January as the greenback trounced most major peers and one gauge of the currency surged 0.9%. Still, while that’s put a slight dent in short positions, most stayed the course, hoping the dollar’s bounce would prove short-lived. The dollar has indeed slipped in recent days, but there’s a nascent-but-growing sense the dollar could have a far better year than expected. It posted small gains versus all of its Group-of-10 peers during the Asian trading day on Friday.

The Hot Macro Trade of 2021 Is Going Bust

At the heart of the case for a stronger dollar is U.S. growth, which looks set to surpass many advanced countries as the nation makes decent progress on vaccinations and Congress debates a $1.9 trillion relief package. Speculation is mounting that the Federal Reserve might need to taper its bond purchases as the economy heats up, and could even consider raising rates in the not-too-distant future. Steadily increasing U.S. yields have meanwhile contributed to a positive feedback loop that sent the Bloomberg Dollar Spot Index to a two-month high last week.

That stands in sharp contrast to the European Union, where a lagging vaccination program and no plans for further fiscal stimulus beyond a package announced in July are hitting investor sentiment. Elsewhere, Latin America will probably be one of the slowest regions to recuperate economically. And in Asia, pockets of inflation are flickering across parts of the continent and fading in others.

This divergence has investors rethinking the conventional wisdom on how government spending will affect the currency, with coordinated fiscal and monetary action unusually providing a reason for the currency to rebound. Heading into the year, bears had expected a weaker greenback amid an era of low rates and large spending under a Democratic-controlled government.

It’s a sign the so-called dollar smile theory -- which posits that the dollar benefits when U.S. growth outperforms much of the world, or when it serves as a haven during crises -- is making a return in trading circles as the new administration gets started. Although Treasury Secretary Janet Yellen has rejected a return to a “strong dollar” policy, she’s also said the U.S. won’t seek a weaker currency -- opting instead for a market-based value.

“If we are in a scenario where fiscal stimulus is more aggressive or arrives sooner than expected, that would be enough to recover some of that U.S. exceptionalism and drive the dollar higher,” said Francesca Fornasari, Insight Investment’s London-based head of currency solutions.

Insight Investment, which manages about $1 trillion, has been short the greenback since mid-2020 and expects accelerating global growth to keep it under pressure. Recently, however, the firm’s executives began asking whether it might be “time to pack up and go neutral,” according to Alex Veroude, chief investment officer for North America.

Short Squeeze

A short squeeze alone could renew the dollar’s rally in the near term. Asset managers dialed back bearish positions by the most in four months last week, according to Commodity Futures Trading Commission data, yet they are still net short. In a report last month, Bank of America said that being short the dollar was one of the most crowded trades among fund managers.

Granted, dollar strength is no sure thing. Firms like Goldman Sachs Group Inc. are so far standing by calls for a structurally weaker currency, and a lot of speculators are still clinging to short positions that will pay out if the benefits of government spending wear thin. The U.S.’s federal budget deficit, which hit a record $3.1 trillion for the fiscal year ended in September, could still ultimately prove unsustainable. And growth elsewhere in the world is set to pick up as inoculations gather pace.

Muscular U.S. fiscal stimulus, financed by money printing in the future, is creating conflicting short- and long-term considerations: It should be positive for the dollar for 2021-2022, though possibly negative for the currency in the long run, according to Stephen Jen, chief executive of Eurizon SLJ Capital Ltd.

For now, investors are taking a beat to reassess their appetite for the U.S. and the dollar, which remains at the center of global trade, capital markets and foreign-exchange reserves.

David Callahan, the Geneva-based head of cash solutions at Lombard Odier Investment Managers, calls U.S. debt levels “a bit scary” and says “it’s difficult to see how much further the U.S. can push the envelope in terms of budget deficit.”

However, he says, American exceptionalism is “still a story that does ring true and might buy the dollar a little more time in terms of being viewed as an exceptional currency and in an exceptional context.”

©2021 Bloomberg L.P.

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