US Yields UP, but Dollar DOWN ..... not only is it counter-intuitive, it's also a bit of a worry

Monday 24th September 2018

US Yields UP, but Dollar DOWN ..... not only is it counter-intuitive, it's also a bit of a worry

ref :- " Dollar Break With Yields Promps Concern U.S. Has Funding Issue " , Bloomberg Markets

We talk about yield spreads quite a lot .... well, doesn't everybody. Somewhat to our surprise (embarrassment ?) we note that we haven't specifically mentioned the US / Germany 10yr spread for quite a while. That's probably a bit remiss of us, bearing in mind that at over 260 basis points the gap between what you can earn on a 10yr US Treasury Note (say 3.07%) and a 10yr German Bund (0.46%) is at its widest since the late 1970s and 1980s. Back then US inflation was about 3% higher than (West) Germany's and you would certainly expect monetary policy to reflect that, but today the difference in inflation rates is comparatively minimal so the current yield premium for US securities is a pretty big deal.

Such a wide (and widening) interest rate differential in favour of US yields would at face value seem to be strongly supportive of the US currency, yet two weeks ago EUR / US$ closed at a touch above $1.15, and on Friday it finished at almost exactly $1.18. Plainly, fundamentally important though they are, interest rate differentials aren't everything ..... not current ones, at least. We must also pay attention to expectations of interest differentials, and the theory that the rest of world is about to embark on a journey of monetary policy normalisation that is already well advanced in the States is one that is being put forward as a reason for Dollar weakness.

Mmm .... we see the argument but that looks like more of a longer-term playbook. People have been saying the same thing for quite a while, but right now the strong growth, very tight labour markets and on-target inflation data in the US means that continuing monetary tightening looks both likely and appropriate for some time yet. In the Eurozone on the other hand, we can certainly hear some slightly less doveish noises from the ECB but their approach is nothing if not cautious.

Probably more of a factor  --  something we spoke about last week  --  is the remarkably phlegmatic manner in which markets are absorbing what some might have assumed was worrying news. Rather than being daunted by such irritants as an escalating trade war, vulnerable emerging markets or even that pesky Brexit, investors have moved towards  "Risk - On" mode, with some even suggesting that the likes of Argentina and Turkey look cheap. That of course is a downer for safe-havens, of which the Dollar comes near the top of the list (along with US Treasuries  --  hence lower prices/higher yields). Such an explanation is also supported by the fact that the only major currency against which the Dollar has gained ground is the Japanese Yen  --  traditionally the ultimate safe-haven currency.

But there's another theory that's slowly gaining traction : Dollar weakness at the same time as rising yields is a function of the reduced appetite for US assets as the spectre of America's twin deficits  --  Fiscal and Current Account  --  begin to loom larger. Yields may rise as the Treasury is forced to borrow more, but not enough to attract the foreign investment required to finance its current account deficit. For that, outside investors require a weaker dollar too. Supporters of the theory would point to Treasury data revealing that domestic investors are taking up a bigger share of an increasing debt burden as evidence. Overseas buyers have proportionately their smallest share of US Treasuries since 2003.

These are indeed curious times, with historically reliable correlations (such as those between comparative interest rates and value of the currency) seemingly being parked to one side for the time being. According to Maoko Ishikawa of JPMorgan Chase in Tokyo, it could just be a temporary anomaly. Once people have a clearer idea of the Fed's plans for next year, and start pricing them in, the old correlations should reassert themselves.

Others are not so sure ..... There are numerous factors behind rising US yields but for convenience's sake Louis Gave of Gavekal Research distills them into just three : the first two are strong growth and rising inflationary pressures  --  neither of those really explain the recent weakness of the dollar, however. A third reading of the situation might be that investors are getting nervous about US deficits and debt ..... and that would explain dollar weakness. According to Mr Gave, it's not necessarily the most likely scenario .... but it's certainly the most worrying.