October 12, 2018 / 11:51 AM / 5 days ago

Commentary: As the greenback strengthens, a tale of two dollars

LONDON (Reuters) - This week’s wobble on Wall Street aside, the U.S. economic and stock market outperformance relative to the rest of the world and the rise in U.S. bond yields has, unsurprisingly, lifted the dollar.

File photo: A packet of former U.S. President Abraham Lincoln five-dollar bill currency is inspected at the Bureau of Engraving and Printing in Washington. REUTERS/Gary Cameron

This also masks a divergence within the greenback itself: it is performing far better against emerging market currencies than developed world currencies.

Since June the 10-year U.S. Treasury yield has risen to a seven-year peak above 3.25 pct, the Fed has raised rates twice and signaled more to come, Wall Street has hit fresh highs and U.S. growth has chugged along nicely.

In that time the dollar has inched up 1 percent against a basket of six major currencies, but has appreciated some 4 pct against emerging market currencies.

(Graphic: Dollar vs EM and G10 FX - reut.rs/2OpxzxK)

The relatively lackluster performance against major currencies, therefore, is baffling, especially as the dollar is enjoying the widest yield advantage over Germany, Britain and Japan in years, in some cases decades.

Both the two- and 10-year U.S.-German spreads are the widest in 30 years; the U.S.-UK 10-year spread is the widest since the mid-1980s and the two-year spread is the widest since the early 1990s; both short- and long-dated U.S.-Japanese spreads are the widest in a decade.

Emerging market yield spreads over Treasuries have widened significantly this year. But of course, there are good reasons for that, namely unpalatable risk and turmoil in emerging economies. Overseas investors have dumped EM bonds accordingly.

(Graphic: JP Morgan EMBI yield spread - reut.rs/2OiBo7L)

What makes the dollar’s schism even more puzzling is the divergence in market positioning, which intuitively points to dollar outperformance against G10 FX, not emerging currencies.

According to Commodity Futures Trading Commission figures, hedge funds and speculators hold a huge net long dollar position against G10 currencies, but are short dollars against EM FX.

The net long position against G10 is now worth nearly $29 billion, the biggest in almost three years. The short position against EM is understandably much smaller, given it’s a far less liquid market, and stands at $1.27 billion.

The positioning shift since June, when the dollar started motoring against EM currencies, underscores that conundrum. Funds and specs flipped to net long dollars vs G10 worth $28.7 billion from a $7.9 billion net short, and to a $1.27 bln net short against EM currencies from being $811 million net long.

That’s a major shift, and a sizeable bet that hasn’t really paid off. What gives?

According to Robin Brooks at the Institute of International Finance, much of the dollar’s relative underperformance against G10 currencies is down to oil.

The rising price of crude - it’s up 15 pct since June, 25 pct this year and 50 pct in the past year - has exacerbated the pressure on the U.S. current account deficit, which has capped the dollar’s upside.

“The dollar versus the G10 remains way below rate differentials, but a lot of that ends up getting eaten away by the negative drag from the rising oil price,” Brooks said. “Oil prices are a historical negative for the dollar, (and) the recent rise has offset supportive rate differentials.”

This is despite the fact that oil’s share in the current account is far smaller than it used to be, although it has been gradually increasing in the last few years, as the pink part in the following IIF chart shows.

(Graphic: Oil as share of US current account reut.rs/2OnCyyI)

But it remains to be seen if that relationship holds. In recent weeks the dollar and oil have recently started moving in tandem, and the correlation between oil and the dollar is now, unusually, positive. Indeed, it is the most positive it has been in three years.

(Graphic: Oil vs dollar correlation - reut.rs/2Oj10RU)

A growing number of analysts now reckon some of the emerging market FX selloff has run its course, leaving some currencies looking cheap. The Turkish lira, which has lost 35 pct of its value against this year, is one of them, Brooks argues.

If the dollar is to continue strengthening, it may now be against developed rather than emerging market currencies.

The opinions expressed here are those of the author, a columnist for Reuters.

Editing by Toby Chopra

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