The conundrum that everyone is wrestling with is the euro and yen's strength given their negative interest rates and prospect for even lower interest rates. The divergence of monetary policy, even if the Fed is on hold for the rest of this year and next, should be dollar-positive.

We have tried making sense of what is happening by separating the developments into two buckets. The first bucket, and what we think is the medium and long-term driver is the divergence of monetary policy. The German and Japanese yields through eight or nine years are negative.  Positive returns are offered in the US. This creates an incentive structure that favors the dollar. 

However, something has erupted in recent weeks that has overshadowed these flows. This is the second bucket.  It has to do with market positioning. The euro and yen have been used to purchase other assets. This is because the cost of borrowing was low or negative and the currencies were weak or falling. As investors liquidated the assets due to changed views or driven by money management considerations, the funding currency had to be bought. 

Another part of this bucket is the unwinding of hedges. Specifically, a popular trade was to buy European stocks and hedge the euro. Japanese stocks would be bought, and the yen hedged. The Dow Jones Stoxx 600 is off more than 16% this year. Italian stock, among the best European performers last year, has fallen by more than a quarter this year. The Nikkei is down 17.5%, and the Topix has fallen 18.3%. The S&P 500 is 11% in comparison. 

Until the very end of last year, the divergence of monetary policy was driven not by the Federal Reserve but by the easing of other central banks, including the introduction of negative rates by the ECB. The Fed's rate hike in mid-December suggested to us a new phase in the divergence meme  Both sides would be moving. Instead, here in mid-Q1 16, it seems that markets are back to the earlier divergence where the BOJ and ECB are easing while the Fed stands pat (for now).