Nomura

Five reasons why US bond yields are no longer driving the US dollar

  • A combination of factors is decoupling the relationship between bond yields and the dollar, which from 2014 to the summer of 2017 had been predictable
  • One possible explanation is that the worsening US trade balance is weakening the correlation between rate spreads and the dollar
  • Another potential reason is that the flow of funds into euro assets is supporting the euro, with a consequent impact on the dollar

From 2014 to the summer of 2017, rate spreads did a good job of explaining the dollar’s movements. The anticipation of higher interest rates made the US dollar more attractive and it appreciated in value.

This positive correlation between US bond yields and the US dollar has since broken down. US bond yields and yield spreads have surged while the dollar has plummeted.

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. But it doesn’t solve the puzzle. This is because both academics and investors have found that UIP only occurs when risk aversion picks up, which is 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:

  1. The dollar has already rallied too much for a Fed hiking cycle
    The dollar rallied over 30% 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 that have been subject to rate hikes. The dollar’s weakness over the past year is likely causing it to return to its more regular behavior in a hiking cycle.
  2. Starting a tightening phase matters more than mid-way hikes
    One lesson from the Fed hiking cycle is that exiting QE (tapering) and early hikes have a much bigger impact on FX than later hikes. The dollar surged against emerging market FX during the taper tantrum and put in its best performance before the first hike in late 2015.
  3. The 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; the US trade balance is worsening while the trade surpluses of the euro area and Japan are growing.
  4. It’s all relative – and the euro is winning the capital flow battle
    An inflow of foreign currencies typically drives the value of a currency to appreciate relative to others. Equity flows into the euro area picked up in 2017 and bond flows could now also be supporting the euro. With growth in the euro area expected to remain strong, peripheral bonds and the euro are likely to perform well.
  5. China matters
    It’s hard to know whether the Chinese renminbi (CNY) is reflecting dollar weakness or causing it. However, the strength of CNY seems to be pulling the dollar lower. Since 2017, the Chinese authorities have reversed the rise in USD/CNY – there is now meaningful CNY strength against the dollar.

For more insights into the decoupling of US yields and the dollar, read the full report on the Global Research Portal.

Contributor

  • Bilal Hafeez

    Head of Fixed Income Research, EMEA

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