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US Dollar and Rates are Variables That Deserve Attention at a Time When Assets are Priced to Perfection

With the markets well ahead of the fundamentals and as money continues to chase performance, the ‘risk’ remains elevated.

Consensus or “crowded trades” can be taken as a contra signal because ‘when all experts agree, something else is bound to happen’. Markets have an uncanny knack for luring investors into a sense of complacency before unleashing the unexpected.

As they say, markets are most vulnerable ‘when the last Bear on the street turns into a Bull’. That’s not far from the current mood as more and more investors who chose to sit out are joining the bandwagon.

Shorting the volatility index has been an extraordinarily bullish and profitable trade due to the inherent leverage in options. Leverage is one of those things that works great until it doesn’t. Volatility is inherently mean-reverting which means when the risk/return is attractive, investors made truck loads piling on shorts at elevated levels.

However, exiting at the opportune moment is often very important. Retail investors have increased risk significantly since the March lows. Investors have not only taken on record levels of risk via speculative call buying but have also simultaneously increased margin debt to record levels.

There are two major risks to the entire ‘Bull market thesis’: Interest Rates and the US Dollar.

For the bulls, the underlying rationale for high valuations has been low inflation and rates. However, given an economy that’s pushing $85 trillion in debt, higher rates and inflation will have immediate and adverse effects.

Given that personal consumption expenditures comprise roughly 70% of economic growth, higher inflation and rates will quickly curtail the ‘reflation’ story.

With the market currently priced to perfection, a disappointment of economic growth (caused by a rising dollar, contraction in consumer spending, or rates) will lead to the repricing of risk.

The one thing that always trips up the market is the one thing that no one is paying attention to – risk lies with the US Dollar. Almost everyone expects the dollar to continuously decline and the falling dollar has been the tailwind for the emerging market along with commodity and equity ‘risk-on’ trades.

The negative correlation of the Dollar with risk assets is well documented. Falling dollar augments the global revenue of US MNCs along with aiding flows into emerging markets. Whatever causes the dollar to reverse will likely bring the equity market down with it.
The relationship between dollar and commodities is even more strong because most commodities are denominated in dollars which means a soft dollar gives a fillip to most commodities.

The positioning story has been in the news lately with the ‘Gamestop saga’ grabbing headlines as large Hedge funds were forced to cut positions leading to a violent short squeeze. While such violent moves are not expected in the currency market, the net short positioning does make the dollar vulnerable to bouts of short squeeze.

Chasing markets is the purest form of speculation. It is just a bet on prices going higher than determining if the price paid for those assets is a discount to fair value. Right now, the tendency is to ignore risks on the horizon because the screen is green by default and the assumption is that rising prices are here to stay but it helps to stop and catch your breath once in a while when everyone else is running around madly.