Dollar Regains Reflation Mojo as Hedge Fund Bets Get Flushed Out

(Bloomberg) -- This time, it seems, hedge fund managers have done the wider market a favor.

Disheartened by the dollar’s five-week selloff to start the year, hedge funds pared back one of their favorite trades -- leveraged bets on the greenback’s gains -- to the least in more than four months last week. That left the currency wide open for a rebound, amplifying the dollar’s surge on the back of President Donald Trump’s vow to overhaul the U.S. tax system.

This week is shaping up as make or break time for reflation trades, which crashed from their late 2016 peaks as the Trump administration hit the ground stumbling when it came to the fiscal stimulus policies that captivated investors after the Nov. 8 presidential election.

Along with optimism tax cuts and spending plans are coming, the focus also shifts to the outlook for interest-rate hikes, with data Wednesday projected to show annual inflation quickened to the fastest pace since 2012. Federal Reserve Chair Janet Yellen is likely to reiterate her willingness to tighten policy in two appearances before Congress, but traders will be watching for any echoes of last year’s move from a gradual pace toward a glacial one.

“The pullback in long dollar spec positioning in recent weeks means the dollar is better placed to rally on upbeat testimony from Yellen and a renewed focus on what could be earlier progress on tax cuts than previously assumed,” said Sean Callow, a senior currency strategist at Westpac Banking Corp. in Sydney.

The Bloomberg Dollar Spot Index built Monday on what was its first weekly advance of 2017, rising 0.1 percent by 6 a.m. London time amid optimism surrounding Trump’s claim he has a “phenomenal” plan to revamp business taxes, more details of which are expected over the next few weeks. The president’s vow Friday to force Asian currencies on to a “level playing field” was overshadowed, with the dollar climbing to its strongest point in February versus the yen and reaching a one-month high against China’s yuan in the offshore market.

Futures indicate traders see only a 30 percent chance of a hike in March, and they aren’t convinced the Fed will boost rates again until June. That’s a stance at odds with both the dollar’s rally and some investors’ bullishness about the economy.

An increase at next month’s meeting is on the table given the economy is likely to see faster growth as “reflation takes hold,” Rick Rieder, BlackRock Inc.’s chief investment officer for global fixed income, said in a blog post Friday. The Fed chief’s appearances come after her deputy, Stanley Fischer, highlighted the “significant uncertainty” surrounding U.S. fiscal policy.

“Yellen’s testimony will be key to the dollar’s continued gains this week,” said Khoon Goh, head of Asia research at Australia & New Zealand Banking Group Ltd. in Singapore. “Any hint that the Fed Open Market Committee will be looking to hike rates again, potentially earlier than what the market is pricing in, will be positive for the dollar.”

While hedge funds may have given up too soon on the greenback, analysts kept the faith. Median forecasts still predict most of the 16 major currencies will rack up losses against the dollar by end-2017, despite the gains they have made this year.

Ten-day volatility on Bloomberg’s dollar gauge, which tracks the greenback against 10 major peers, has fallen to its lowest this year, a sign confidence in the reflation trade is returning.

The Treasury market is also signaling traders may have been too quick to discount the prospects for a greenback revival. While the dollar reversed about half of its post-U.S. election surge in 2017 trading to the start of this month, Treasury yields remain elevated above the 2.3 percent level breached within a week of Trump’s victory.

Still, the specter of U.S. tensions over trade -- particularly with Asia -- will continue to linger around the dollar, says Janu Chan, a senior economist at St. George Bank Ltd. in Sydney. At least two Fed rate hikes are also already “priced in” to the currency, she said.

To read more about other potential Asian trade targets for Trump, click here.

“Longer term, we don’t have the dollar index much higher than it is currently,” Chan said. “There are the tax cuts, deregulation and infrastructure spending, which are dollar positive, but then protectionist policies are dollar negative.”

“Any uncertainty or geographical tension could weigh on the dollar.”

--With assistance from Garfield Reynolds To contact Bloomberg News staff for this story: Emma O'Brien in Beijing at eobrien6@bloomberg.net, Liau Y-Sing in Kuala Lumpur at yliau@bloomberg.net. To contact the editors responsible for this story: Christopher Anstey at canstey@bloomberg.net, Tan Hwee Ann at hatan@bloomberg.net, Garfield Reynolds

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