To be fair, maybe the Dollar isn’t done yet

Outlook: Today we got lucky and were delivered an FX outlook by Reuters’ market guru Dolan, who knows a hawk from a handsaw in any market. We wrote yesterday that the dollar pushback was due but would not be long-lasting, and now we have information we don’t normally watch to help the narrative.

Dolan writes that it’s FX marking the end of the interest rate cycle. 

Look at Deutsche Bank's CVIX (.DBCVIX), a weighted average of implied volatility in the 9 major FX rates. Note that more than 50% of the index is due to the 3-month implied volatility in the euro/dollar and dollar/yen.

This month it hit the lowest since Dec 2022, just before Russia invaded Ukraine and also just before the Fed became hawkish. “By driving short-term dollar cash rates and U.S. bond yields higher over the past 20 months, the Fed basically sucked cash from the wider investment world and supercharged dollar exchange rates everywhere. Now that it looks done, the buck's finally on the back foot - plumbing levels not seen since August.

“In what ING strategists Chris Turner and Francesco Pesole describe as the dollar's ‘long goodbye’ - 2024 looks set to for a persistent, trending bear market for the greenback that in itself will sap volatility as risk markets reflate on the back of central bank easing hopes.

“With implied volatility directionally biased, the dollar index and the CVIX are typically well correlated and both peaked in tandem in same month of September last year. That bias is mainly due to the disruptive aspect of dollar strength - which adds to economic, trade and financial stress around the world via inflation of commodity import prices as well as pressuring dollar-denominated debts in many emerging nations.

“That sensitivity, in turn, creates friction and often leading to extreme more extreme monetary policies or even open market intervention to push back - and making a sharp dollar ascent more noisy along the way.”

In Japan, where the noise is deafening, the BoJ is at the trough on rates while the US has peaked, so now they are leaning toward one another—so vol is dissipating and the dollar/yen is getting the respite.

The euro and sterling are both delivering converging rates and yields. Either or both could pre-empt the Fed on that first cut. On a related front, the yen’s role in the carry trade is confused, if not gone. And the ridiculously unmeasurable “term premium” worries may have kept the dollar higher than it should have over the past 2 months, and now the chickens are coming home to roost. 

To be fair, maybe the dollar isn’t done yet. “Morgan Stanley thinks the DXY index could rebound up to 8% from here to some 111 before finally falling back later in 2024. The argument is that near-term direction remains foggy as rate differentials likely continue to favour the buck through the first half of the year while growth and geopolitical risks support keeping a defensive stance in dollar cash.”

See the chart, published without a title. The white line is the Deutsche Bank FX volatility index. We like correlations, but do not like volatility in any of its costumes, real or implied. We know that implied volatility is only distantly related to historical volatility, or used to be, although edging ever closer to one another.

But volatility in the form of options trading tends to be a function of a minority of the market. We don’t know a percentage number, but perhaps 25%? This is probably on the same scale as many long-term managers like sovereign funds and sovereign reserve managers and insurance companies (et al.), who make their decisions on the big macro economic trends, including growth and debt burden.

This is not to disrespect the vol index. But it’s also to warn that like so many correlated things, it’s not 100% and not to be trusted for every blessed move. There is often something that comes bursting on the scene from left field and upsets seemingly solid relationships. This includes war, natural disasters and one-time things like assassinations. In the anniversary week of the JFK assassination, we shouldn’t forget that.  

Forecast: The dollar consolidation ahead of the holiday is proceeding apace but it’s not clear how far it can go, with many trading rooms working but with a skeleton crew starting around noon. The only question is whether the Big Banks and other managers will have more positions to pare on Friday ahead of the weekend. 

Note to Readers: Tomorrow is Thanksgiving. We will close all trading positions at noon today and there will be no reports on Thursday or Friday.

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