Morgan Stanley on the US dollar

Following the 2% pullback in USD since the start of the year, we take stock of where market sentiment and positioning currently are.

The Daily Sentiment Index, compiled from a survey of traders, measures short-term market sentiment among futures traders. Our preliminary analysis suggests that the index appears to be a useful contrarian indicator for USD, though more statistical analysis needs to be done to see if it can be used as a consistent trading signal. When the index reaches extreme levels (85% and 15%), it tends to mark a turnaround in USD. In November/December, USD bullish sentiment reached an extreme of 90% and declined subsequently, bringing USD down with it (Exhibit 9). Sentiment is now more moderately bullish (67%), reducing the potential downside for USD, if it occurs.

Looking at positioning using CFTC data, USD long positions have moderated following the USD decline. Long USD positions have scaled back by a third from the peak at the start of the year. We compute the z-score to look at where current positioning stands relative to the rolling 1-year average. Statistically,a z-score of +2/-2is extreme and tends to lead to positioning adjustment, which has an impact on USD. The latest z-score for USD positioning has fallen to 0.8, which is not extreme (Exhibit 11), suggesting that the room for USD to decline further as positioning adjusts may be limited.

However, the risk for USD may come from the extreme short positioning in US Treasuries. Short positioning in 10-year UST has barely changed since the start of the year and is still extreme, with a z-score of -2.1 (Exhibit 12), leaving US yields vulnerable to a further decline if positioning continues to adjust, pushing yield differentials against USD.

Bottom line, we think the USD has scaled back to levels where it could resume its rally. The risk outlook remains positive as US financial conditions have eased and global trade data has improved, implying that the 'good' USD strength may be back in play. Yellen's speeches next week will be in focus. We look for commentary on whether she will stick with herview of three hikes this year. With the markets only pricing a 25% chance of a March Fed hike, there is potential for her to surprise hawkishly, supporting USD strength.

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