The so-called ‘Trump reflation trade’ started unraveling before Christmas Day, 2016. As expectations of inflation eroded and the expected path of the Fed’s policy rate became shallower, the dollar began to weaken. By the summer, all concerned agreed that the whole reflation trade had been priced out and then some. The dollar rebounded. But then…it started falling all over again.

This appeared to be a great mystery and generated considerable talk about whether the US Treasury Secretary was talking down the dollar. The FT‘s well-respected market commentator, John Authers, noted,

Has the US dollar stopped making sense? US rates are rising, and a long-run bull market in Treasury bonds seems to be over. This is not happening elsewhere, so the differential between US and European yields has risen to its highest since the euro came into being in 1999. That should mean a rising US dollar and falling US stocks. But US stocks are shooting for the moon and the dollar is tumbling — down 13 per cent from last year’s high on a trade-weighted basis. One retort is that the US has just passed a big tax cut. Of course that raises earnings this year — so buy stocks and sell Treasuries. But it should also be a reason to buy dollars. And stocks that benefit most from the tax cut are doing no better than anyone else this year. This renders the weak dollar the more mystifying.

Matt Klein, one of the sharpest knives in the FT‘s drawer, offered that there was no mystery, it had to do with growth expectations in Europe/RoW rising relative to the United States. This would be the standard (nonfinancial) macro explanation of dollar weakness. As we shall see, he is not entirely wrong. Although the mechanism is not as straightforward as he implies.

In a followup, Authers later shared a comment from a trader that pointed to a massive carry trade underway whereby you borrow dollars to fund euro forwards. According to this trader, there was supermassive 100 basis point (ie, 1 percent) carry in the trade. This, he/she alleged, was the cause of dollar weakness.

I realized that there is a very easy way to check this. Such a carry would only exist if fwd rates deep in the curve were much higher on the continent than in America. Gavyn Davies had already noted the empirical case for this. We can do much, much better than suggestive visual evidence. Indeed, we will see how this can be nailed down mathematically.

We appeal to what’s called uncovered interest rate parity, which says that the home interest rate equals the foreign interest rate plus the expected rate of depreciation of the home currency. It imposes a consistency condition on the euro/dollar spot exchange rate on the one hand and the yield curves prevailing in America and on the continent on the other. Matt is right about changes in expectations about relative growth rates in the United States and the eurozone. What this means is that the US yield curve has become flatter than the German yield curve and that has opened up the carry that Authers’ trader gushed about.

The proof is a straightforward calculation of uncovered interest rate parity. Figure 3 displays the expected future exchange rate implied by the yield curves displayed in Figure 2 via the UIP equation as well as the spot rate.

The interpretation is straightforward. Change is relative growth expectations between the United States and Europe led to relative movements in the yield curves which opened up a huge carry trade opportunity. And that massive carry trade put downward pressure on the spot rate for the dollar. Here’s a graph of the carry implied by the yield curves together with the spot exchange rate.

An interesting question that arises then is whether the carry trade consumed so much dealer balance sheet capacity that it precipitated the risk-off that began last week and culminated on Vol Monday. Perhaps that is why US bank stocks (but not European) did so well on Monday despite the volatility shock. If that is the case, we would’ve nailed two birds with one stone.