As noted yesterday, the Australian dollar is suddenly caught between the thermal of reflation and commodity prices versus the wind shear of rising US bond yields and inflation. Last night saw more of the same as risk markets were hit but key commodity prices, especially iron ore, rose. MUFG has more on inflation and yields:
The US dollar has stabilized at modestly higher levels overnight as it holds on to gains at the start of this week. The dollar index has moved back towards the middle of the narrow 90.000 to 92.000 trading range that has been in place since December of last year. The US dollar has lost some upward momentum after US yields failed to continue to push higher despite the release of stronger than expected US economic data. The 10-year US Treasury yield has fallen back towards 1.28% after hitting an intro-day high of 1.33%yesterday. While the 10-year US Treasury yield has risen by around 43 basis points since the start of December, the dollar index has fallen by around 1.0% highlighting that the relationship between higher long-term US yields and a stronger US dollar has been weak recently. Nevertheless, market participants remain nervous that a sharp move higher in US yields will trigger a larger rebound for the US dollar which could be exacerbated by still elevated short US dollar positioning. The fundamental case for a move higher in US yields was supported yesterday by the release of stronger than expected US economic data. It was revealed that retail sales expanded well above consensus expectations by 5.3% in January which was the strongest reading for seven months. The report showed broad-based strength with the strongest gains in discretionary categories such as department stores (23.5%), restaurants/bars (6.9%), furniture (12.0%) and electronics/appliances(14.7%). It points towards a significant acceleration in consumer spending in Q1following the weaker end to last year. The decision by Congress to pass the USD900 billion fiscal stimulus package at the end of last year appears to have had a more immediate impact at supporting growth than expected. The package included providing another round of USD600 stimulus checks to most Americans. The USTreasury distributed more than USD130 billion of stimulus in January. The willingness of US consumers to spend could show more confidence in the economic recovery. Market participants’ confidence in the economic recovery will have been strengthened as well knowing that the Biden administration is planning to send out another round of USD1,400 stimulus checks. Upward pressure on long-term yields also reflects building concerns over upside risks to the inflation outlook. Those concerns were heightened yesterday by the release of the stronger than expected producer price report for January.
It is now my base that US yields go higher during an unfolding inflation panic:
I think this is also likely to drive volatility in stocks. Both may well lift the USD through H1.
Moreover, as said yesterday, if USD strength transpires on the basis of tearaway US growth and yields, then I can see it rolling into the Chinese slowdown that will begin in H2, meaning it can continue as CNY and EUR roll together.
The problem is, with everybody bearish the USD, it’s kind of bullish. Take Societe Generale:
Our forecasts reflect a belief that US policy and vaccine optimism will give the global economy a big boost and that this will be broadly dollar-negative this year. However, there are caveats. First, an outsized dollar long position could keep EUR/USD in check in 1Q. Second, while rising US bond yields are not a major problem for asset markets when they are still low, especially in real terms, a sudden adjustment can cause equity markets some pain. The Fed’s main task in the weeks ahead may be to ensure that the market correction remains orderly. Third, we think the dollar’s low point will come this year, not in 2022.
The FX market built up a large net dollar long position in 2018, and this finally turned negative last year. In December, net short positions reached a level seen only a very few times over the past decade, and since then, the situation has not changed. There is a decent backward-looking correlation between CFTC positioning and the dollar’s three-month performance, and the longer the dollar remains in its current range, the greater the pressure for dollar shorts to be cut back. Until that happens, EUR/USD in particular (as the most-traded currency pair) will struggle to rise. At the end of last summer, the market cut back its short dollar position while the FX market meandered, and that made room for a fresh fall. So far this year, the net dollar short hasn’t gone anywhere, EUR/USD has drifted a little lower, but the dollar has weakened against other key currencies. We hope that’s an indicator of how the adjustment can play out–with EUR/USD moving above 1.25in the second half of the year against a backdrop of a weaker dollar overall. That would see EUR/USD risingwithout causing too dramatic a gain in the euro’s trade-weighted value.
Conversely, the Australian dollar positioning is neutral, oddly so for such a strong reflation trade:
So, there is room for the AUD to be bid if commodity prices hold up which they may if the USD does not suddenly take off. But, the higher it goes, the more they will struggle until such a time as the Fed steps in.
To my mind, then, the Australian dollar is caught between two very powerful forces that probably prevent any high volatility move either way for now. And given that I see China slowing in H2 and iron ore coming off, there is a real chance that the AUD is already traversing through a long topping process.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
