Dollar's Lost Link With U.S. Yields Could Return, Here's How

Updated on
  • Faster Fed hikes, delayed ECB tightening are among triggers
  • Strategist split on how long the correlation break might last
BNP Paribas' Morris Expects Dollar Depreciation to Continue

It’s a simple proposition. Higher interest rates make a currency more attractive, so it should appreciate. But it doesn’t always work that way.

The dollar is now trading around its weakest in three years, at the same time as benchmark U.S. Treasury yields are around their highest in three and a half years. The broken link can be seen most easily when looking at the dollar against the yen, as in the chart below.

Markets love narratives, and the one that’s spreading now for the dollar is that the U.S. current-account deficit, and prospects for a widening federal budget gap, are bad for the currency. That’s not always been true, but that’s the story gaining traction among analysts -- and it could get an extra boost from U.S. Treasury Secretary Steve Mnuchin saying in Davos Wednesday that a weaker dollar is good for trade.

What could change the narrative? Here are some recently proposed options:

  • The Federal Reserve turns more aggressive than expected, driving up U.S. rates and taking the dollar with them.
  • The European Central Bank delays plans for tightening monetary policy.
  • The U.S. trade balance improves. (The International Monetary Fund sees a modest worsening, to 2.62 percent of GDP this year and 2.73 percent next year -- still well below the levels of the 2000s.)
  • China stops allowing the yuan to appreciate against the dollar.
  • Bonds of peripheral European countries, like Spain, stop performing well, hurting capital inflows into the euro.

The above ideas come from Bilal Hafeez, global head of G10 foreign-exchange strategy at Nomura Holdings Inc. in London. Some combination of those five dynamics would need to emerge for U.S. bond yields to drive the dollar again, he says.

For now, "we remain comfortable holding a bearish dollar view even if U.S. bond yields are rising," Hafeez wrote in a Jan. 23 note.

Over at Bank of America Merrill Lynch, the team sees the correlation breakdown between dollar-yen and the yield spread as a temporary affair.

"This seems fundamentally driven by a concern about the U.S. twin deficits, potentially aggravated by the tax reform" enacted last month, Shusuke Yamada, a currency and equity strategist at Merrill Lynch Japan, wrote in a Jan. 24 note. "We argue that the market underprices the potential impact of the tax reform on long-term economic growth and its positive implication for the dollar."

Yamada predicts the yen will sink to 120 per dollar in the first half of 2018. It was at 109.66 as of 8:55 a.m. in London Wednesday.

(Updates with Treasury secretary comment on the dollar, in third paragraph.)
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