USD traders ignore rate differentials and look over the rainbow
- Analysts were caught out by bullish dollar calls in 2017
- Yield curve flattening is the best guide to US dollar prospects
- Traders discount rate differentials today in favour of bigger payoffs
By Max McKegg
Analysts reviewing their predictions for 2017 must be scratching their heads wondering how the bullish consensus around the US dollar turned out to be so wide of the mark. The USD index peaked early in January and spent the rest of the year declining. As shown in the chart below, it’s now delicately poised as the new year begins.
The perplexing thing for analysts was that their expectations for the US fundamentals came to pass. The Federal Reserve raised rates three times; tax cuts were enacted; the economy started to expand at a rate above potential and unemployment fell below its natural level. This was a good enough recipe for adrenalin junkies in the stock market so why didn’t US dollar traders join in?
Traders may be looking over the rainbow at prospects for other leading currencies, and they may see today’s rate differentials in favour of USD as reflecting old news. Photo: Shutterstock
The answer was that they didn’t see the proof in the pudding: If the economy was on such a roll, then where was the inflation? Others may have noticed that previous rate hikes and tax cuts did not always coincide with USD strength, as the chart shows (click to enlarge).
USD index chart
Source: Metastock. Create your own charts with SaxoTrader; click here to learn more.
The bond market, which takes a long term view of things, sat the year out, leaving the yield on the 10-year Treasury bond where it started, despite the impetus of higher rates at the short end of the curve. This flattening of the yield curve gives a clue as to why the dollar failed to gain any momentum. Traditionally rate differentials at the short end are the best guide to change in FX rates, but not so in 2017. The spread between US and German two-year government bond yields widened to more than 250 basis points, the highest since the euro debuted in 1999.
Despite this hindrance, EURUSD rallied. It seems traders were looking through to a time when the rate differential was going to narrow.
Euro yield spread chart
USDJPY spent most the year tied at the hip to the US 10-year bond yield or, more specifically, the spread over the Japanese equivalent. But with the Bank of Japan successfully implementing its yield curve control policy (holding the 10-year JGB at “around zero percent”), USDJPY became highly correlated with movement in the US bond.
Understandably, many assumed this was causation rather than correlation but, as shown in the chart below (click to enlarge) the relationship became less clear cut from October 2017 onwards.
If inflation is the missing link in the US that is holding back the dollar, then why is the same effect not being felt by the euro and yen (that is, in the EU and Japan), where inflation is even lower?
Over the holidays at the end of 2017, an inflation update out of Japan showed the headline rate coming in at 0.9% year-on-year. This was a slight improvement on the previous month, but excluding energy price effects the annual rate was an anaemic 0.3%, showing there are few “home grown” price pressures.
Japan’s economy is now expanding above its potential and the unemployment rate has dropped to 2.7%. Theoretically this should be putting pressure on resources, especially the labour market, resulting in higher input costs for business and a flow through to consumer prices. But in recent speech Bank of Japan Governor Haruhiko Kuroda put his finger on what’s going on in the background saying “many firms have been making efforts to raise their labor productivity and absorb increases in wage costs rather than raising their sales prices”.
Kuroda observed there has been a significant increase in labor-saving and efficiency improving software investment in areas such as construction, retail, accommodation and restaurants. More specifically, “hotels are using artificial intelligence or robots to take care of their customers, construction firms are introducing drones and transportation firms are halving the number of workers at warehouses by building automated ones”, he said.
These are structural, not “transitory” influences, and if, as seems likely, similar developments are at play in other major economies central bankers might have to rely on factors other than wage increases to generate and sustain 2% inflation.
One of those factors could be exchange rate movements. A weaker dollar will give a modest inflation boost to the US, but the flipside is that it will be a hindrance elsewhere. As the following chart shows, the European Central Bank already has ambitious inflation projections but these assume EURUSD holds around 1.1700 throughout the forecast period. Any further strength in EURUSD would not be helpful.
EUR inflation chart
So with inflation remaining moribund in the US, Eurozone and Japan, why is USD being singled out and sold?
The best explanation is that the market thinks the current level of inflation in the US is as good as it’s going to get. The flattening yield curve would support this view. Meanwhile in Japan and the Eurozone there is more upside potential for inflation, even though it’s well hidden at the moment. Accordingly there is likely to be more monetary policy tightening over the medium term from the Bank of Japan and the European Central Bank than the Federal Reserve.
This would suggest the FX market is capable of taking a long term view saying that today’s interest rate differentials in favour of USD reflect old news, and that there’s money to be made by looking somewhere over the rainbow. And out there, the euro and the yen are the stars.
For more on forex, click here.
– Edited by Robert Ryan
Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.