Even as most consensus trades hit the jackpot again in the first weeks of the year, global investors have been left puzzled by one refusenik – a suddenly enlivened US dollar. Partly because a bouncing buck just doesn’t fit with the rest of the prevailing “reflation” narrative, many currency analysts have just put its reversal down to an overstretch. And make no mistake, there were few dollar lovers coming in to 2021. COVID vaccines had arrived to goose a global recovery and de-stress the financial system further, political risks around US elections appeared to have passed and the Federal Reserve continued to “out print” other central banks in its bond buying and balance sheet expansion. Global fund managers polled by Bank of America last month saw “short US dollars” as the second most crowded trade on the planet, only behind US tech stocks. And speculative hedge fund positioning recorded by the CFTC – negative since March – last week threw up its biggest net dollar short for almost four months. But a combination of these position extremes and rising US Treasury yields, fueled by ramped up fiscal stimulus bets as the Democrats swept up an unlikely Senate majority in Georgia last week, has prompted a rethink. Morgan Stanley and Deutsche Bank teams at least switched long-standing negative dollar recommendations to neutral – even if Deutsche described the change as largely “tactical”. And yet investors clearly saw something shift right from the Senate results – at least partly because the new fiscal possibilities take pressure off the Fed. “The prospect of more fiscal policy and less monetary stimulus should support the US dollar,” David Page, Head of Macro Research at AXA Investment Managers, said last week, adding that some of the 5% dollar drop since the November elections should now be unwound. Lo and behold, the dollar index – which had virtually ignored steadily rising US Treasury yields since August – burst 1.5% higher this week as nominal 10-year US Treasury yields jumped almost 25 basis points to more than 1% for the first time since March. Fed Vice Chair Richard Clarida virtually blessed the move on Friday by saying the Fed would not react to the breach of 1% – undermining any remaining speculation the Fed would implicitly adopt some rigid yield cap around those levels. SPOILING THE NARRATIVE But why the dollar suddenly reacted is less obvious as its role in the wider “reflation” narrative to date as been to weaken. After all, if a Democrat sweep adds a fiscal spur alongside an inflation-tolerant Fed, then the presumption of accelerating consumer price rises down the line – enough to keep lifting stocks and commodities – should continue to sink the dollar too. But it all pre-supposes inflation does indeed come through with gusto. And here the bond markets have been less clear cut than it seems at first glance. While nominal Treasury yields have surged, market inflation expectations have moved less so because real, or inflation-protected, Treasury yields have moved higher too. The implied 10-year inflation expectations embedded in that constellation topped 2% for the first time in two years. But they have stalled just above the Fed’s target about 2.10%. They remain well within levels seen over the past 10 years, when the Fed’s favoured measure of core inflation never actually matched the breach on any sustainable basis. The jury on inflation remains out. The pandemic is still raging, with swathes of spare capacity across economies to persist long after vaccines roll out. And we have yet to see details on US fiscal firecrackers, let alone how a razor-thin Senate majority will hold. As nominal rates stalked zero, sinking of US 10-year real rates below -1.0% was a powerful driver of dollar weakness last year. If the Fed was to cap nominal yields, the argument went, then the only expression of inflation fears would be ever more negative real rates that would take the currency down with them. But not only have real rates backed up above -1.0%, but the real rate US premium over German and euro zone equivalents has risen to its highest this week since May 1.