FxWirePro: Macro level hedging radar amid fading interest rates and political tail risks

The USD index has set a new low for the year having dropped 1.25% on the Fed’s caution. Not only that, the dollar has now retraced over 60% of the entire Trump rally, which goes a long way to validating a key assumption in our forecast this year which is that tighter US monetary policy is not a sufficient condition to extend an already mature rally in a structurally overvalued dollar.

The pressure on the dollar from the Fed is liable to be compounded by the re-think about European political risk which was underway before the Dutch election and then sustained by the failure of the right-wing populists to make their electoral mark. This fading of interest rate and political tail risk should manifest itself both in continued outperformance from high-beta and high-carry currencies (EM and non-oil commodity FX) as well as a creeping recovery in Europe/USD in line with improved macro performance in the region and less hostile ECB policy.

The dollar’s growing discount to interest rate spreads (now at 2.3%) provides a hint of the potential pressure on broader US capital outflows and the dollar if investors get more comfortable  positioning for superior growth outside of the US (and less anxious that US trade policy will disrupt this).

To reflect this changing balance of risks we are adding some modest outright pro-risk exposure to the portfolio in addition to largely neutralizing the small net USD long and increasing implicit exposure to the European recovery. To gain exposure to growth and carry dynamics in G10 we buy AUDCAD in cash and close a long-standing risk-hedge in AUDJPY at a loss.

We stay long USDCAD for now, as CAD has over-reacted to the move in US rates and is now 1% undervalued, but this is hedged against the risk of a deeper setback to USD by the long position in AUDCAD (AUD would continue to outperform CAD in a falling USD environment). While many EM currencies are too overvalued to own, ILS is one where idiosyncratic factors should compensate (external imbalances, bond index inclusion) and justify further advances. We sell EURILS.