Dollar Gain Slows as Focus Turns to Flat Curve From Yield Spread

  • Widening yield premiums to Japan, Germany fail to boost dollar
  • Curve flattens to April low on bets Fed liftoff to be gradual

The dollar’s surge is losing steam against the euro and yen as investors shift their attention to how fast the Federal Reserve will raise interest rates next year from whether the first increase in almost a decade will come in December.

The greenback retreated from Wednesday’s seven-month high versus the euro and three-month high against the yen even as U.S. two-year yields offered the widest premium over Japanese securities since 2010 and over German debt since 2006. The currency instead heeded calls from Fed officials that U.S. rates be raised gradually as the job market heals and policy makers gain confidence that inflation will accelerate toward their 2 percent goal.

“While the spread in the short end of the curve is widening, currencies are trailing because there is no vision for a successive tightening and the yield curve isn’t steepening,” said Jun Kato, a senior fund manager in Tokyo at Shinkin Asset Management. “That’s deterring aggressive dollar buying against the yen.”

The dollar was little changed at 122.86 yen as of 2:10 p.m. in Tokyo after sliding 0.6 percent Thursday, the biggest drop since Oct. 14. The U.S. currency was at $1.0715 per euro from $1.0734. On Wednesday, it reached a seven-month high of $1.0617 per euro and a three-month high of 123.76 yen.

Source: Bloomberg

The greenback has fallen 2.4 percent against the Japanese currency since reaching a 13-year high of 125.86 on June 5. Since that peak, the spread between two-year U.S. and Japanese yields has widened 20 basis points to 92, the biggest gap since April 2010, as a larger-than-forecast gain in U.S. payrolls for October helped boost the odds of a Fed rate increase.

The flattening U.S. yield curve is now the issue for the dollar. The difference between two- and 10-year Treasuries narrowed to 134 basis points Friday, the smallest gap since April, after some Fed officials suggested that rates will rise gradually.

“The longer-dated yield may be reflecting concerns that a rate hike would lead to recession,” said Yoshinori Shigemi, a global market strategist in Tokyo at JPMorgan Asset Management. “That may be weighing on the dollar relative to the two-year yield spread. The greenback may have become less sensitive to yield gaps, or in other words, markets are finding it difficult to buy dollars.”

125 Hurdle

The greenback will struggle to climb beyond 125 yen as disinflation in Europe and falling commodity prices spur demand for the Japanese currency as a haven, according to Shinkin Asset’s Kato. In addition, Japanese officials probably want to prevent further yen weakness from hurting consumers, he said.

Currency options indicate investors are cautious about the dollar’s prospects. One-month risk reversals have stayed negative for almost two weeks, signaling an increase in demand for the right to sell the greenback for yen.

“The inability of dollar-yen to follow the widening two-year Treasury-JGB spread reflects the yen already being very weak, so further downside for the currency is limited,” said Mansoor Mohi-uddin, senior markets strategist at Royal Bank of Scotland Group Plc. in Singapore.

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