The Dollar's Rebound Is a Lesson for Investors

(Bloomberg) -- For the first time in what seems like ages, the dollar is experiencing a pronounced rally. Yet you can bet that most traders aren't happy about this turn of events.

First, a short tutorial. For years, most traders (myself included) bought and sold currencies based on interest-rate differentials. For example, if the Federal Reserve is hiking interest rates and the European Central Bank is not, you can borrow money cheaply from a European bank, exchange it into dollars, and deposit those dollars into a U.S. bank where rates are high and going higher. Everyone doing this all at once would drive the U.S. dollar higher and the euro lower. This is how the currency market is supposed to work. And it worked that way for years.

But trading currencies based on rate differentials suddenly stopped working last year. The one major economy that was reliably raising rates, the U.S., saw its currency depreciate. The Bloomberg Dollar Index plunged 8.52 percent. Europe, with its negative rates and running monetary policy experiments even more radical than the Japanese, saw its currency appreciate. The Bloomberg Europe Index soared 9.80 percent. That threw everyone for a loop. People tried to rationalize it in different ways. They said the chaos of the Trump administration when combined with illiberal trade policies was hurting the dollar. They said the free-market Macron administration in France would strengthen Europe. Either way, these are qualitative, rather than quantitative, reasons to sell dollars, so the trade didn't make sense. In fact, traders complained for a year that nothing made any sense. 

Then something interesting happened — traders got used to nothing making sense. When trading, you have to go with what works, and shorting the dollar was working. Even as recently as a few weeks ago, the broad consensus was that the dollar would be weakening further, especially as U.S. debt and deficits soared.

There's an old adage that the market does whatever causes the most pain to the maximum number of people.  And given that the market had built up extreme bearish dollar positions, it became apparent that any signs of strength would make shorting the dollar the new “pain trade.” 

You can make a pretty good return by looking around to see which trades are crowded, which is to say where sentiment becomes very one-sided, and betting the other way. For currencies, rates and commodities, all you have to do is look at the weekly Commodity Futures Trading Commission commitment of traders reports and see how the market is positioned. In stocks, you can look at short interest — or the lack of it.  There is some disagreement about whether this sort of thing actually works, but my experience has been that for the most part, it does.

What other pain trades are lurking? Well, bond yields have been going more or less straight up over the last few months, and it has become “free money” to be short bonds.  Sure enough, positioning in bond futures has reached extreme short levels. It's hard to imagine a scenario where bond yields go down, with increased supply hitting the market and the Federal Reserve showing no signs of slowing the pace of interest-rate increases. But what is certain is that the short-term pain trade would be for bond yields to go lower.

I added the caveat “short-term” because the true pain trade for the U.S. economy is higher rates. Every corporation, municipality, and household absolutely depends upon rates remaining low.  If 10-year bond yields went from 3 percent to 5 percent in relatively short order, it would be catastrophic — the true long-term pain trade. But on a short-term basis, speculators would be harmed the most if yields went down.  And since the market does what causes the most pain to the greatest number of people — that is probably what will happen.

Market moves are a lot easier to understand if you view the market as a collection of human beings who all tend to cluster around the same beliefs. It might seem to be harder to predict human behavior rather than the fundamentals, but actually it isn't. All the economics degrees in the world would have been no help in trading the euro-dollar exchange rate in the last year. This is the essence of trading, and why the need for judgment of a skilled trader will never fully disappear. 

To contact the author of this story: Jared Dillian at j.dillian@bloomberg.net.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.

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