Markets are difficult to predict. Whenever we take comfort in understanding them, we are reminded how temperamental they can be. This is precisely what has happened with US bond yields and the dollar.
From 2014 to last summer, rate spreads seemed to do a good job at explaining movements in the dollar. The anticipation of higher interest rates made the US dollar more attractive and the dollar appreciated in value.
The positive correlation between US bond yields and the US dollar, however, has since decoupled. US bond yields and yield spreads have surged while the dollar has plummeted.
Although uncovered interest parity (UIP) – a parity condition where a higher-yielding currency should weaken to offset the interest rate spread or carry – might explain the drop in the dollar, it doesn’t solve the puzzle. This is because both academics and investors have found that UIP only occurs when risk aversion picks up, clearly not the case in this situation. So what’s going on?
Here are five factors that explain the divergence between US bond yields and the dollar:
The dollar has already rallied too much for a Fed hiking cycle
The dollar already rallied over 30 per cent on a trade-weighted basis from 2013 to 2016. During previous Fed hiking cycles the dollar has typically weakened and since 2008, it has far outperformed other currencies, whose central banks hiked. The dollar’s weakness over the past year is likely bringing it back down to its more usual performance in a hiking cycle.
Starting a tightening phase matters more than mid-way hikes
One lesson from the Fed hiking cycle was that exiting QE (tapering) and early hikes have a much bigger impact on FX than later hikes. The dollar has already surged against emerging market FX during the taper tantrum and put in its best performance up until the first hike in late 2015.
US trade deficit is a problem
Typically, when the US trade balance worsens, the correlation between rate spreads and the dollar weakens. This was the case in the early 2000s, when the dollar ignored Fed hikes as the current account was worsening. Today, the situation is similar as the US trade balance is worsening while the trade surpluses of the euro area and Japan are growing.
It’s all relative – euro is winning the capital flow battle
The inflow of foreign currencies will typically drive the value of the dollar to appreciate relative to other currencies and the euro area is winning the race so far. Equity flows into the euro area picked up in 2017 and now it seems bond flows could also be supporting the euro. With Italian election risk likely to be low and growth in the euro area likely to remain strong, peripheral bonds and the euro are likely to perform well.
It’s often hard to know whether the Chinese yuan (CNY) is reflecting dollar weakness or causing it, however, it seems like the strength of the yuan is pulling the dollar lower. Since 2017, the Chinese authorities have reversed the rise in USD/CNY and we are seeing meaningful CNY strength against the dollar.
It is the combination of these factors that is uncoupling the relationship between bond yields and the dollar and keeping it at bay. For more insight into the decoupling of US yields and the dollar, read the full report on the Global Research Portal.