Yield Divide Emerges as Key Driver of Dollar Strength Versus Yen

  • Greenback’s rally may extend as Fed leans toward rate hike
  • Swaps show tightest link since 2010 between currencies, yields

Foreign-exchange traders should turn to their colleagues on interest-rate desks for clues about the direction on the greenback.

The dollar’s three-week rally against the yen can be traced to the correlation between the currencies and short-term interest-rate swaps, which has risen to near the highest since 2010. This linkage boosts the effect of the increasing divergence in interest rates, which may continue based on the growing consensus that the Federal Reserve is getting closer to raising rates, while the Bank of Japan is committed to keeping negative borrowing costs unchanged.

"The yield spread is moving in the dollar’s favor," said Richard Franulovich, chief currency strategist for the northern hemisphere at Westpac Banking Corp. in New York. "The yen is becoming more sensitive to the yield spread, as U.S. yields push higher and Japanese government bond yields are steadier."

The recent rally has helped the dollar pare its 13 percent decline versus the Japanese currency this year. The greenback’s weakness caught most analysts by surprise. Forecasts at the start of the year called for U.S. currency strength with yen demand crimped by the BOJ’s bond-buying and a move to negative interest rates.

The dollar added 1.2 percent this week to 104.18 yen, its third straight five-day increase, marking the longest streak since May. The Bloomberg Dollar Spot Index, which tracks the currency against 10 major peers, rose 0.9 percent.

The gap between U.S. and Japan two-year swap rates swelled to as high as 1.17 percentage points this week, up from 0.88 percentage point on July 6, according to data compiled by Bloomberg. The extra yield that investors demand to own two-year Treasuries instead of similar-maturity Japanese government bond climbed to as high as 1.13 percentage points from 0.82 percentage point on Aug. 4.

Fed Watch

The minutes of the Federal Open Market Committee’s Sept. 20-21 meeting released Oct. 12 described the decision to refrain from tightening as a close call, with several saying a rate hike was needed “relatively soon.” A speech Friday by Fed Chair Janet Yellen didn’t sway market-based measures of the outlook for tighter U.S. monetary policy.

Futures show the likelihood of a hike by year-end climbed to 66 percent, from 50 percent on Sept. 27. The calculation is based on the assumption the effective federal funds rate will trade at the middle of the new range after the central bank’s next increase.

The two-year interest-rate differential "is the number-one variable to watch," said Greg Anderson, global head of foreign-exchange strategy in New York at Bank of Montreal. "There’s potential for the Japanese rates to move lower and U.S. rates to move higher."

BMO expects the dollar to strengthen to 106 yen by year-end.

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