Mistakes made and lessons learned on the dollar reversal - Nomura

Bilal Hafeez, analysts at Nomura, noted that the euro fell 4.5% from the middle of April until last week. 

Key Quotes:

"While it is easy to explain these moves in hindsight, it may be more useful to understand why I missed them as the moves were unfolding:

1) Missing the reduction in trade war fears. I identified the trade war as a dollarnegative factor, but missing the reversal of trade war fears in early April. There was clearly a “buy the rumour, sell the fact” dynamic, where the anticipation of tariffs saw dollar weakness, but the actual announcements saw the dollar gain versus the yen. 

2) Not acting on my implicit euro bearishness. It is notable that I barely talked about the euro, and constantly talked about expressing a short dollar view against the yen, rather than the euro. I should have recognised that my lack of conviction around the euro in the context of excessive dollar bearish sentiment in the market was a signal of trouble for the euro. 

3) Not focusing enough on inflation. The 13 March US CPI release showed a flat core inflation reading (1.8% y-o-y), but the 11 April US CPI report showed core inflation rising to 2.1%. Meanwhile, the 28 Feb euro-area CPI release showed a flat reading (1%), but the later 4 April report failed to show an increase despite consensus expectations for a rise. With oil prices jumping on Iran deal risk fears over the course of April, the stage was set for a surge in US yields between 17 April and 25 April when 10yr yields jumped from 2.83% to 3.02%. This saw the beginning of pronounced broad dollar strength. 

4) Getting the “risk-off” trade wrong. The clear message in my writing was that markets were in unstable and risky times. I chose the yen to position for this, but that was a mistake. I ignored the fact that investors were heavily long yen, and so any risk aversion would initially see those positions unwind and hence see yen weakness. I also underplayed the impact of higher US yields on the yen. From my notes, I clearly thought the backdrop of a trade war would minimise the impact of yields, but I didn’t factor in that waning trade war fears would see yields reassert themselves as a driver of USD/JPY. Finally, on a more yen-specific side, I failed to notice the growing trend of M&A outflows from Japan – admittedly these are hard to predict.

What does this mean for the current dollar view in the context of these four lessons?

First, trade war fears have abated, so the question is when they might re-emerge. Currently, China and the US appear to be engaged in a slow-burning technology trade war, and the rhetoric on either side could escalate from 22 May when the public hearings on proposed US tariffs end and actual tariffs could start to be implemented.

Second, my cognitive dissonance bias of staying away from the euro, rather than openly being bearish is less of an issue. The reason I say this is that IMM positioning shows leveraged funds are now flat euros (rather than very long), and as a reflection of a negative sentiment, euro risk reversals were close to their lowest levels in a year last week. Similarly for the yen, leveraged fund positions are close to flat. So now there is less of a crowded trade to fight against. 

Third, inflation is a mixed bag. Euro-area inflation has recently disappointed to the downside, but so have US inflation data. Ideally, I would need to see euro-area inflation pick up, perhaps preceded by a growth pick-up, to increase my confidence that the inflation divergence story is behind us. Moreover, most expect the Fed to hike at the 13 June meeting which the dollar is certainly pricing too. Typically, the dollar does well in the run-up to a hike, rather than after the actual hike, so the actual hike could see those gains tempered.

Finally, it has been reassuring that during the recent EM FX collapse USD/JPY has not risen. On top of that, while the initial oil price jump (and rise in US yields) on Iran fears in April saw USD/JPY rise, this month when the US actually exited the deal has not seen a similar rise in the dollar. This suggests that the yen is regaining some of its “safe-haven” characteristics. 

Adding this all up, our conviction to be short USD/JPY at current levels is high thanks to trade war risks not being priced, recent US inflation disappointment, the yen performing as well as the dollar during the EM sell-off and the proximity of an actual Fed hike (which caps Fed hike expectations). The picture for the euro is less clear; we have a bias for strength as excessive bullishness has been unwound, but we need confirmation that inflation (and growth) has troughed."