Why is the US dollar dropping when yields are rising?
- The US inflation update beat forecasts, but USD traders are looking elsewhere
- EURUSD rose even as yield spread hit a 12 month high
- Bond market term premium holds the key to the US dollar's fortunes
By Max McKegg
Wednesday’s update to the US consumer price index (CPI) beat expectations, the core rate coming in at 0.3% month on month. The actual number was 0.349%, just short of being rounded up to an official 0.4% print which would have been double forecasts and really set the cat amongst the pidgins.
As it was the yield on the 10-year Treasury bond rose to 2.90%, but once again traders who were banking on higher rates lifting the dollar were disappointed. EURUSD moved up (as my FX Trading Analysis/Forecasts projected) even as the spread between Treasuries and the German bund equivalent rose to 215 basis points, a one-year high. The following chart shows an expanding spread eventually toppled the EUR in 2014 but clearly that point hasn’t been reached this time around.
Euro versus 10 year spread
Source: Bloomberg. Create your own charts with SaxoTrader; click here to learn more.
One explanation for this is that markets are forward looking. They see scope for rate differentials to narrow as the Federal Reserve completes its policy rate normalisation plans in the next 18 months or so just as the European Central Bank is getting underway from a much lower base.
For USD to rally against the EUR something needs to happen to change this mindset. A few basis points on the bond yield won’t do it.
The Federal Open Market Committee meets on March 20-21 The following chart shows the Committee’s December “dot plot” for the Federal funds rate versus market expectations based on the OIS (Overnight Index Swap) and fed funds futures curves. The median dot shows the Committee is leaning towards a rate hike in March and the market curves have moved up to price that in (almost).
Traders probably assume we are late in the economic cycle and the “sugar rush” of the US administration’s fiscal spending will be shortlived. Photo: Shutterstock
But further out the market curves continue to languish under the dot plot. Traders don’t think conditions will justify rate hikes at that pace, probably on the assumption we are already late in the economic cycle and the “sugar rush” of the US administration’s fiscal spending will be shortlived. Hence inflation will struggle to attain and settle at the Fed’s 2% target.
The Fed thinks otherwise and is likely to stick with the program in March and perhaps even up the ante. The dollar won’t rally until traders are convinced the Fed is right and they are wrong, in other words, until the OIS and fed funds curves rise to the dot plot
Dot plot (Federal funds rate versus market expectations)
But splitting hairs over 25 basis point rate hikes at the short end of the curve has little impact on long-term bond yields.
Bond yields are a combination of two key factors: the risk neutral yield and the term premium. The risk neutral yield is set by market expectations of where short term rates will be in the future.
The dot plot guidance is that the Fed funds rate will gradually rise to around 3% over the medium term and settle there.
On this “risk neutral basis” then, the yield on the 10-year Treasury should be about 3%, as illustrated by the green line on the chart below.
The second factor influencing yields is the term premium: the extra return investors demand to compensate them for the risk of holding medium term bonds. As the following chart shows, the term premium has actually been negative for some time. Deduct the negative term premium from the risk neutral yield and you end up with the current yield of about 2.9%.
US 10 year risk neutral chart
The market is roughly in agreement with the Fed’s outlook for short term rates in the long term and so little change in the risk neutral curve can be expected (it would require a substantial revision of the US economy’s medium term growth prospects). That means a rise in the term premium will be needed to drive the 10-year bond yield higher from here. A rise of 100 basis points, still below the term premium’s long term average, would drive the 10-year yield up to 4%.
That would start attracting some interest in US dollar. Why is the term premium below zero?
There are two main reasons:
- Investors see inflation risks skewed to the downside i.e. they are prepared to pay a high price for bonds because they value them as a hedge against low inflation. Wednesday’s CPI update will do nothing to change that notion, and
- The Fed itself estimates its bond buying activities (and sitting on its holdings for the last few years) took about 100 basis points off the term premium.
The reason the dollar is unable to gain traction of late is that money markets, not the Fed, are behind the curve. Traders and investors need to get on board with the Fed’s flight path for the policy rate over 2019-2020 and, more importantly, start pricing in a higher risk premium.
It’s not as if the risks aren’t there for all to see: just look at the fiscal largesse being promised by the US administration and the expansion of the bond issuance program that will accompany it.
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– Edited by Robert Ryan
Max McKegg is managing director of Technical Research Limited. If you would like to receive his Daily FX Trading Forecasts, you are welcome to contact him (see his contact details here).