Hunt is on for the next hot currency as US dollar starts to ebb

Hedge funds are scouring for the right currencies to bet against as the opportunities to profit from wagering on the dollar’s strength ebb, according to a money manager, which invests in the funds.

Managers expect the greenback’s gains to be less pronounced following its rally in the last three quarters, said Sam Diedrich, a director at Pacific Alternative Asset Management, which oversees about US$9.5 billion in hedge fund investments. What was once the most popular trade in the foreign exchange market has this month fallen out of favour as a gauge of the dollar declined 2.5 per cent this quarter, following a 20 per cent rally in the nine months ended March 31.

“The gains will be made more on the other side of the currency,” Mr Diedrich said in an interview by phone from Irvine, California. “It won’t be a story about the dollar; it will be a story about the idiosyncratic weakness in a particular currency pair.”

Forecasters expect the dollar to climb about 7 per cent versus the euro and about 3 per cent against the yen by December 31, compared with a 14 per cent advance against each last year. They are most bearish on the Argentine peso, Russian rouble and Brazilian real among 31 major currencies, predicting declines of as much as 17 per cent against the dollar.

A survey of fund managers from Bank of America Merrill Lynch showed that 69 per cent expect the US dollar to appreciate over the next 12 months, up slightly from April’s reading. In contrast, a net 32 and 35 per cent expect the Euro and yen to decline. Yen bearishness has risen by 16 percentage points since March.

As of yesterday, the dollar was up 11.4 per cent versus the euro and 8.9 per cent versus the yen for the year to date.

There has not been a strong consensus among hedge funds on which currencies they want to bet against, Mr Diedrich said.

“There hasn’t been a clear trend that’s been established on the back of this washout because it’s still going on a little bit,” he said.

Hedge funds and other large speculators trimmed bets on dollar gains for a seventh straight week in the period through May 12, according to the latest data from the Commodity Futures Trading Commission in Washington. The wagers have dropped by about a third since the end of March.

Managers have pushed back expectations for a US interest rate hike to September, at the earliest, amid lacklustre economic data, Mr Diedrich said. Federal Reserve officials signalled they are unlikely to raise borrowing costs in June, while leaving open the option of tightening later in the year, according to minutes of their April meeting released last week in Washington.

“The US dollar will remain well bid and stable and continue to appreciate, but not at the same pace,” Mr Diedrich said. “The performance gain in FX going forward will be less about going long dollar and more about which currencies you’re long the dollar against.”

Separately, the European bond sell-off of 2015 that erased $300bn from the market has run its course, at least according to options prices on German bond futures.

Traders are the least bearish on Europe’s benchmark sovereign securities since the plunge started. They are paying almost the same for derivatives granting the right to buy German bund futures, or calls, as to sell them over the next month using puts.

The turnabout took hold in Europe as oil fell, undercutting concern about brewing inflation that only two weeks earlier had sparked a rout in fixed income markets on several continents. European Central Bank policy makers on Tuesday then said they would speed purchases of debt in their $1.2 trillion quantitative easing plan, widening the safety net for the region’s $6tn of sovereign securities.

“That bullish comment by the ECB took the cat away from the pigeons,” said Richard McGuire, the head of European rates strategy at Rabobank International in London. “Some investors we talked to said they were monitoring the sell-off with an eye to possible re-initiation of long positions,” he said, referring to bets that asset prices will rise.

A greater degree of stability in the bond market as the sell-off dissipates may create a virtuous circle, allowing buyers scarred by the sell-off to return. That in turn would enable companies and governments to raise funds in the debt market with greater confidence that the cost of borrowing will not be distorted by exaggerated price gyrations.

The premium for puts over calls on what is Europe’s bond bellwether last week shrunk to as little as 0.40 percentage point, the smallest on a closing basis since bunds and bund futures began their plunge on April 29. Later they widened to 0.91 per cent, still down from a premium of 1.78 percentage point on May 13.

A separate gauge of investor bias also showed bears in retreat. A put-call ratio, or proportion of outstanding puts to calls on the benchmark German bund future, dropped to 0.63 on Tuesday, the lowest since November.

“We are told the economy should be reflating toward the end of the year, and the sell-off was partly driven by people scaling back on deflation risk,” said Frances Hudson, a strategist at Standard Life Investments in Edinburgh. “But in Europe, there is no strong evidence where growth will be coming from. Any increase in yields from here could be hampered by economic uncertainty and ECB action.”

Standard Life, which oversees $488bn, has maintained a “heavy: or overweight position on European bonds, according to Ms Hudson.

Inflation expectations were cooled after oil prices retrenched. Brent crude futures have dropped about 1.2 per cent in May to $65.98 per barrel, having risen 21 per cent in April.

“The decline in crude oil prices – which we expect to extend – has stabilised bond markets,” Francesco Garzarelli, a fixed income strategist at Goldman Sachs, wrote in an emailed note. “We expect crude to remain in a narrower range going forward, with diminishing effects on headline inflation.”

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