Beware the consensus

By Ugo Lancioni, head of global currency at Neuberger Berman

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’ve learned not to fight the ECB or the Bank of Japan, either. So whatever you do, don’t fight all three at once.

Last year that meant being long the US dollar. The Federal Reserve had been readying the market for policy tightening since summer 2013.

By October 2014 “tapering” of its quantitative easing program (QE) was underway 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 enormous program 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.

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 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 that it will take a gradual approach to tightening.

But even without this turnaround it would still look to us as though last year’s fundamentals are now priced in.

The final pages of this story are being turned and investors have been forced to scale down some of their more extreme exposures, but overall market positioning suggests many still expect another twist to the plot: the chart showing speculative positioning indicates that the market remains net-long the dollar; and the Barclay Hedge BTOP FX Index, which seeks to replicate the currency sector of the managed futures industry, has been more than 60% correlated with the US dollar index over the past three months, according to Bloomberg data.

This doesn’t mean we think it’s time to short the dollar or buy the euro, but we do think the risk-reward profile of maintaining a sizeable euro short is no longer very attractive from a relative-fundamental perspective.

It is likely that 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 that the ECB will maintain ultra-loose policy has led investors to re-affirm 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.

The Japanese yen has responded to risk aversion in this way for decades. Despite holding its own against most other currencies during the most difficult days of the Greece negotiations, the euro still lost around 2% against the yen.

We are cautiously overweight the yen, but market positioning suggests we are fighting the consensus on this.

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