FX: Once again the dollar is up as investors "rethink" the Fed's stance. This year has been tough for our dollar bullish bias, primarily because of the Fed tightening cycle guessing game. When will the Fed be done? When will the peak in Fed funds rate that justifies several months of extreme dollar bearishness finally arrive? These are the predominant questions driving dollar trading in 2006.
Having digested Chairman Bernanke's testimony last week, traders are yet again showing considerable uncertainty over what to expect in early August. We think that the market's preoccupation with the very near-term impact in the interpretation of a pause has once again caused them to "jump the gun" in assuming the end of tightening, and that the dollar bears will once again be foiled by FOMC's priority with data-confirmed inflationary pressures.
History supports this claim as Bernanke has come to odds with the market's reaction to his Congressional testimony once before. Recall early May of this year when the interpretation of a near-term pause in Fed tightening proved to be as premature as it was misguided. Everyone got a little egg on their face: investors for reading too closely into Ben's comments, a certain CNBC anchor who leaked the revelations that the "markets got it wrong", and the Chairman himself for his inability to recognize the market sensitivity to his every word. Since then, Bernanke proved to have learned a valuable lesson, keeping a tight lid on the immediate monetary policy actions, and his decline to comment on whether the "markets got it right" on the second day of his testimony is very telling. In a research note last week, we said: "Whether this lesson (premature response) was learned by the speculators remains to be seen in whether the dollar bears can hold on to their gains - we remain skeptical for several reasons." Thus far, the dollar rebound this week confirms our skepticism.
Aside from inflation sensitivity being one of the reasons, we emphasized the extreme dollar bearishness that is being built up among the major hedge funds. The net long positioning in the hedge funds' favored anti-dollar vehicle - EURUSD - that we show below is at a point where we need to consider the risk of the "depletion of dollar-bearish ammo".
Furthermore, even when the Fed does decide to pause, the bias should remain tilted to the USD side. Although counterintuitive at first, it is hardly surprising that the peak of Fed funds rates has historically coincided with dollar rallies, as bearish positioning ahead of the end of tightening suggests profit taking after the last hike. Logically, a dollar-bearish bias involves having established dollar-short positions. As dollar bearishness soars to record highs, the profit-taking potential upon completion of a tightening cycle surges as well.
Today's USD rally that comes so soon following a dovish interpretation of Bernanke testimony is merely a hint of this potential of unwinding dollar shorts. Once this guessing game over the end of tightening played out in the FX markets this year has run its course, the remaining positive yield differential should support USD.
