Sometimes fighting the consensus can be dangerous and going with the flow is often the safest way to generate returns.
It is well known that trading against the major central banks can be perilous, for example. “Don’t fight the Fed,” as they say.
Recently we have learned not to fight the ECB or the Bank of Japan, either. So whatever you do, do not fight all three at once.
Last year, that meant being long the dollar.
The Federal Reserve had been readying the market for policy tightening since summer 2013. By October 2014, tapering of its quantitative easing (QE) programme was under way and the end of the year saw the first serious discussion about the timing of a rate hike.
The ECB, by contrast, finally announced its intention to begin QE, and the Bank of Japan, which had been pumping liquidity into markets since 2010, continued to expand its programme in October 2014.
The so-called ‘central bank divergence trade’ became a hit among investors, who loaded up on dollars and, between May 2014 and March 2015, watched those dollars appreciate by almost a third against the euro.
The final page
But there comes a point with all good stories when the final page is turned. The fundamental dynamics started to change this year, with the ECB’s QE programme taking effect and European inflation expectations and economic activity showing faint signs of recovery.
The first quarter even saw disappointing data from the US, albeit temporarily, and the Fed has assured the market it will take a gradual approach to tightening.
Even without this turnaround it would still look as though last year’s fundamentals are priced in. We are into the final pages of this story and investors have been forced to scale down their more extreme exposures, but overall market positioning suggests many still expect another twist in the plot.
The chart to the left shows speculative positioning, indicating the market remains net long the dollar; and the Barclays Hedge BTOP FX Index, which seeks to replicate the currency sector of the managed futures industry, has been more than 60% correlated with the dollar index over the past three months, according to Bloomberg data.
This does not mean we think it is time to short the dollar or buy the euro, but the risk-reward profile of maintaining a sizeable euro short is no longer attractive from a relative fundamental perspective.
It is likely investors have maintained euro shorts because of the ongoing Greek drama and an assumption that the ECB will maintain its loose policy stance for a very long time. But it is interesting to note the resilience of the single currency during the June-July flare-up of the Greece crisis.
This is probably because confidence the ECB will maintain ultra-loose policy has led investors to reaffirm the status of the euro as a funding currency for positions in higher-yielding risk assets.
As such, when we see bouts of risk aversion, the euro behaves like a safe haven as investors buy it back to close out those positions.