With Janet Yellen set to speak in just a few minutes, traders are scrambling to position ahead of what while most expect will be a snoozer speech, could actually be a "big surprise" as RBC's cross-asset strategist Charlie McElligott warns in his Jackson Hole preview that, noting that the risk of a dollar rally today is non-zero.
Here is what McElligott thinks will be the catalyst for a sharp move higher in the dollar, and lower in the Euro: "If Chair Yellen uses today’s “financial stability’ theme as grounds for leaning ever-so-slightly hawkish despite the flurry of CPI misses (while Draghi is ‘close to the vest’ and doesn’t say much at all to thrill the Euro bulls), you could get a SHARP move higher in USD, as rates diffs shift counter-trend. And if USD gaps higher, this is a disruption of correlations to the “policy convergence” trade previously discussed"
As such, a tactical squeeze in the massive leveraged-fund USD is a possibility that could jolt a number of consensus trades in the market. Is this my ‘base case’ today? No. But it’s worthy of being mentioned, especially in light of month- and Summer- end illiquidity.
To be sure, it won't take much to shake out leveraged funds which as shown in the chart below, are the shortest the dollar in over 4 years, and longest the euro in 3 years.
Are FX traders about to get whipped around again with countless stops getting hit: the answer in just over half an hour.
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Full note from RBC's Charlie McElligott
THE RISKS OF A DOLLAR RALLY / REVERSAL TODAY IS 'NON-ZERO'
So let’s mark-to-market JH: I would say that the key determination will be contextualizing the ‘relativity’ of Yellen’s message to that of Draghi’s in ‘market neutral’ fashion—after all, this is about maintaining the nascent ‘evolution’ from nearly four years of central bank ‘policy divergence’ to the new regime being express over the past four months—that of ‘policy convergence.’ This will ultimately be the catalyst for whether rates differentials drive further USD weakness to maintain the status-quo macro trading environment (weaker Dollar vs rest of world dragging rates lower with it, and providing a tailwind for US exporters….versus the G10 central banks who are pivoting ‘less dovish,’ seeing their currencies strengthen, in turn, dragging their respective equities markets)…or whether we instead see a short-term / positioning-driven ‘tactical reversal’ in the bearish USD story.
As previously-stated, there has been a ton of debate since Draghi’s late June Sintra speech on whether he intended that to be interpreted as ‘hawkishly’ as it was. The thing is--and as we’ve said all along--this wasn’t about ‘hawkishness’ per se, but was about being ‘less dovish,’ which marks a nuanced philosophical inflection and an acknowledgement from Draghi that by nearly all measures, the ECB now must begin the messaging process to announce the eventual tapering of asset-purchases in early ‘18. Thus, the market took the ball and ‘ran’ with this message—Dollar further unglued, Euro ripping since.
And even as the EUR has run 6 big figures since Sintra (1.12 to 1.182ish last), it is critical to note in the micro-term what Draghi didn’t say this week in his final speaking engagement prior to JH—meaning, there was zero mention of Euro strength. This was later followed-up by ECB’s Ardo Hansson:
“We’ve been moving in a corridor where I don’t think it’s a big change,” Hansson said. “It’s not surprising that markets might react and say, on balance, we’re more upbeat about Europe than we were a while ago, which will cause the currency to be a bit stronger.”
Thus, much of the fear of ‘aggressively dovish’ jawboning from Draghi tomorrow (to ‘backtrack’ on the currency strength) has since been again moderated, which in turn has allowed for ‘policy convergence’ Euro bulls to ‘run.’ EURUSD calls are trading at a premium after chunky upside buying WTD, driving front-end vol skew significantly higher (chart below vs last wk), and this morning we see EUR back to said 1.182 level, taking out some fresh stops above 1.18… while conversely, the trade-weighted Dollar indices are lower, as status quo is seemingly set to maintain.
What then is today’s key market risk to consensus belief? Just thinking about ‘blind spots,’ I believe it might come from Janet Yellen and not Draghi actually--who will be so incredibly ‘measured’ to not let the ‘tapering’ cat out of the bag until either Sep or Oct ECB meetings….despite likely too attempting to counterbalance that messaging with a potential QE extension in his pocket in an attempt to neturalize a ‘too hawkish’ response in the financial conditions. But that is looking out into the future…for TODAY, I believe it will be Draghi who is the ‘red herring’ and is likely to be a snoozer.
Instead, the ‘risk’ is about the ‘relativity’ here of ‘Yellen : Draghi.’ If Chair Yellen uses today’s “financial stability’ theme as grounds for leaning ever-so-slightly hawkish despite the flurry of CPI misses (while Draghi is ‘close to the vest’ and doesn’t say much at all to thrill the Euro bulls), you could get a SHARP move higher in USD, as rates diffs shift counter-trend. And if USD gaps higher, this is a disruption of correlations to the “policy convergence” trade previously discussed (to be clear though, I expect this to be a short-term counter-trend reversal, as over the course of Q4 the ‘rest of world’ CBs will remain biased ‘less dovish’ with ongoing expansive data).
The acceleration of the ‘Weak Dollar’ trade has not surprisingly correlated with the fixed-income / rates rally, with the rally in US mega-cap exporter equities / FAANG, with the outperformance of ‘Growth and Low Vol’ factors versus ‘Value’ and ‘Size’ (small cap), with the rally in EM and is obviously inherent / implied against the mega-rallies experienced in majority of G10 FX (SEK +10.2% vs Dollar over past four months, NOK +9.4%, DKK +8.7%, CAD +7.9%, AUD +4.5%, CHF +3.3%, NZD +2.9%) vs respective local equities underperformance to US.
As such, a tactical squeeze in the massive leveraged-fund USD is a possibility that could jolt a number of consensus trades in the market. Is this my ‘base case’ today? No. But it’s worthy of being mentioned, especially in light of month- and Summer- end illiquidity.