Dollar bandwagon starting to get a little crowded

A currency trader counts US 100-dollar notes.
Ali Mohammadi | Bloomberg | Getty Images
A currency trader counts US 100-dollar notes.

No question, the U.S. dollar is the trade du jour.

Investors are betting on the buck for good reason: The U.S. economy is outperforming other global economies, and the Federal Reserve is moving closer to raising interest rates. At the same time, other central banks in Europe and Japan are moving in the opposite direction, easing policy to fight both deflation and slow growth.

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That divergence in central bank policies has resulted in a $46 billion bullish trade on the dollar.

In fact, hedge funds and other large speculators are betting the dollar will strengthen against all major currencies, according to the latest weekly Commodity Futures Trading Commission report on futures positions. Traders have been increasing bullish dollar positions steadily since mid-May.

The enthusiasm is shared by forecasters as well.

Market in pre-holiday lull: Expert
Market in pre-holiday lull: Expert   

Scotiabank said euro forecasts against the dollar from major Wall Street firms have fallen from 1.28 in August to 1.20 in November. They've also been upping their predictions for the dollar against the Japanese yen, British pound, Canadian dollar and Australia's dollar.

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Camilla Sutton, chief FX Strategist at Scotiabank, pointed out that the options market is also signaling growing bullish sentiment on the dollar. So-called risk reversals, or the difference in volatility between put and call options, show increasing demand for protection for a strong dollar in recent months.

Furthermore, in Bank of America Merrill Lynch's October survey of fund managers, 44 percent said that long dollar positions are the most crowded trades. Long high-yield was the second-highest trade, with 20 percent of respondents saying it was the most crowded trade.

All of this extreme bullish sentiment can be a red flag.

The danger with consensus calls and crowded trades? Any news or data release that pokes holes in the strong dollar story has the potential to cause a massive rush for the exits and could get messy. Once confidence is shaken, it can lead to a sharp snapback as the trade unwinds.

"U.S. dollar speculative positioning is increasingly becoming a very crowded trade, which leaves it more vulnerable to pullbacks in the near-term on the back of disappointing economic data from the U.S. which acts to dampen Fed rate hike expectations," Lee Hardman, currency analyst at Bank of Tokyo Mitsubishi, said in a note.

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Many see the dollar's reaction to Friday's jobs report as a sign sentiment is starting to play a greater role.

The economy added 214,000 positions in October, slightly worse than the 235,000 expected by economists. Still, there were a number of positives in the report, including the unemployment rate falling to a six-year low of 5.8 percent and broad-based gains in jobs across industries.

The dollar dropped the most in three weeks.

"The dollar's inability to rally on the back of this solid report suggests to us the market, in looking for a blockbuster report, has gotten ahead of itself in positioning for a U.S. decoupling," BofAML strategist David Woo said in a report this week.

"The market has gone a long way in positioning for another U.S. dollar positive Fed 'catalyst' following the (Fed Open Market Committee's) more upbeat labor market tone in October, on the back of a continued declining in initial jobless claims, strong manufacturing survey employment components and above-consensus (third-quarter gross domestic product). However, the otherwise solid report failed to provide such an impetus in the face of already significant U.S. dollar positioning," Woo said.

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In other words, now that the dollar has already strengthened 10 percent in a four-month period, rallying a record 12 weeks in a row into October, the bar is now set higher for the strong dollar to get even stronger.

"As a result, we see the risks for a U.S. dollar consolidation in the coming 4-6 weeks. However, continued labor market progress will likely push the Fed toward its first hike supporting our longer-term bullish U.S. dollar view into 2015," Woo said.

And after a persistent and steady climb this fall, the dollar has stumbled a bit lately on its way up.

"The dollar trend has been very powerful since July, and it impacted fund returns positively, especially in September. Since then, the trend has been more erratic, which is indirect evidence that the position is getting more crowded," said Jens Nordvig, managing director and head of fixed income and currency strategy at Nomura.

Since more traders are piling into one side of the trade, watch out for more corrections and stumbles.

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The two big risks to the bullish dollar story: Weaker-than-expected economic data and dovish comments from the Fed, playing down its return to a normal world of higher interest rates.

"If at some point the Fed expresses concern about the headline inflation trend, it will be a problem and could see unwinding of U.S. dollar longs in bigger sizes," Nordvig said.

Bottom line: The reasons people are pouring into the dollar are good ones. A divergence in central bank policies between the Fed and other major central bank players is likely to dominate market moves in 2015, and there's no single more powerful pull on currencies than divergent monetary policies.

Even Fed Chairman Janet Yellen warned in Paris last week that "the speed and timing of normalization will likely differ across countries based on the pace of each recovery."

So while the case for a stronger dollar is sound, buyer beware: The heavy positioning and extreme sentiment may mean it could be a bumpy ride.

You may even have to wait for the new year to see the next meaningful move up.