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Summary
- Sharp moves lower in US yields and the US dollar (USD) index (DXY) this month have taken both to multi-month lows.
- We think these outsized market reactions are in large part due to lopsided market positioning (long USD and short the US rates market).
- After the big market moves, we think a clear-out has occurred, and that market positioning is now much cleaner.
Market Implications
- The DXY will now trade in a ~104/108 range in the coming weeks.
- The 2-year US treasury yield will trade in a ~4.8%-5.2% range, with the US 10-year yield to trade in a ~4.5%-5.0% range.
Introduction
In the past two weeks or so, the DXY and US yields have pulled back sharply from the year-to-date highs seen last month.
The first down leg was prompted by the US Treasury’s Quarterly Refunding Announcement (QRA), the Fed’s rate decision, and the US jobs report, all of which led to a dovish reaction from the US rates market and the USD.
This initial lurch lower accelerated Tuesday with the release of US CPI data, taking US yields and the dollar to multi-month lows.
Our view is that these outsized moves seen this month were largely due to crowded positioning (long the USD and short the US rates market).
After the flush lower in yields and the dollar, we think that positioning is much cleaner, and that both the DXY and the US rates markets will now consolidate in the coming weeks.
Cleaner Positioning Will Allow USD to Consolidate
Since the US Treasury’s QRA and the Fed’s latest rate decision, the past two weeks have seen whipsaw price action in the USD. During 1-3 November, the USD dollar index (DXY) dropped a little over 2% from peak to trough. After that, it retraced about half its fall, bouncing a little under 1% from the low.
Tuesday’s CPI release saw the DXY blow through the low earlier this month and traded at the lowest since early September. As we said last week, we saw scope for additional USD downside this week.
We think the DXY decline will probably pause near this ~104 level. Tuesday’s move was massive, so the sell-off probably shook out a lot of crowded long USD positioning. And with this shakeout, that positioning now is almost certainly much cleaner than it was at the beginning of this week.
The USD had a long bull run, lasting from mid-July to early October, when the DXY rose about 8%. A material pullback off the highs was probably overdue, and the drop seen this month, culminating in yesterday’s slide, will probably now consolidate and range-trade.
US Rates Market Price Action Will Be Similar to USD
We can trace much of the DXY volatility to price action in the US rates market. Since the beginning of Q4, the 2-year US treasury yield has thrashed around in a ~45bp range, between 4.80% and 5.25%. We now sit near the bottom of the range.
Before Tuesday, the Q4 range in the 10-year had been about 50bp wide, between 4.5% and 5.0%. The market blew through the previous MTD low yesterday and, like the DXY, trades at the lowest since early September.
The dovish price action this month has been driven by markets broadly concluding that the Fed rate hiking cycle is now complete. Tuesday’s CPI data solidified this view. As is almost always the case, the late-cycle price action has been volatile and choppy. It will probably continue to be so in coming weeks. As in FX, crowded positioning in the US rates market, expecting higher yields, is now almost certainly much cleaner.
Whether the market is correct about the Fed policy rate peaking, with the next move a cut in mid-2024, is yet to be seen. Nonetheless, like with the USD, we expect the US rates market to consolidate at current levels and range-trade.
USD/JPY Sell-Off Takes Some Pressure Off the MoF
USD/JPY sold off sharply Tuesday, a move the MoF will welcome. After printing a new YTD high on Monday, near the 30+ year peak in October 2022, this probably removes some MoF intervention threat.
Before yesterday’s USD/JPY decline, we were on alert for potential MoF intervention. And if USD/JPY grinds back up to the YTD high (which it probably will), we see a strong possibility the MoF will intervene to oppose JPY weakness.
Should that happen, USD/JPY could fall substantially (we reckon the pair could trade down to 140/143 on MoF intervention). When the MoF intervened in October 2022, USD/JPY fell from ~152 to 140 within 15 trading days. That dragged the DXY down about 5% over the same period.
And, while history might not necessarily repeat, we recognise MoF intervention could lead to material downside in USD/JPY, which would spill over into the DXY.
Premature to Turn Short USD
Nearly four months have passed since our last dose of Fed tightening. Now Tuesday’s CPI release has left the idea of a December hike in the rearview mirror. So, what is the play in G10 FX? We find:
- USD tends to outperform into the final hike. Thereafter, it can outperform for a few months (Chart 1).
- JPY tends to underperform G10 after the final Fed hike. So, while USD can stage one final mini rally, which is then pared, JPY forgets to join in. Historically, JPY could fall another 8% against USD (156 area from the last Fed hike).
- Turning short USD works once cuts have started (Chart 2). So, turning short USD now is likely premature.
Richard Jones writes about FX and rates markets for Macro Hive. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side.