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Will Rising US Bond Yields Continue to Support the Dollar?
The recent spike higher in US bond yields has added a new element to a forex market that has looked to other factors given that central bank monetary policy is seen on hold for the foreseeable future. The question is whether the sharp rise is US yields is a positive or negative for the dollar. In the short run, the market is taking it as a positive sign but will it last?
John wrote an article 6 years ago on how interest rates and expectations of changes in future monetary policy impact the forex market. This extract from it is a good primer on what traditionally drives the forex market.
Foreign Exchange is all about the value of one currency against another, and the cost (or return) on a given currency is its interest rate. Traditionally, forex values have been driven by relative interest rates, but in the wake of the "Great Recession", we have gone through an unprecedented eight year period of near-zero interest rates in major economies… Many like the two-year differential because it amounts to a market forecast of the administered overnight deposit rate set by the central banks. Exchange rates tend to be highly sensitive to changes in the expectations for monetary policy.
It is hard to believe we are still talking about zero interest rates 6 years after this article was published but this is the hand we are currently dealt. In this regard, with short term interest rates seen as staying unchanged for an extended period (e.g. US 2 year note 0.14%), attention has shifted to the 10 year bond yield.
As noted above, the question is whether the sharp spike in US yields, such as the 10 year, is a positive or negative for the dollar. Much will depend on the reasons behind higher yields and whether the Fed changes policy as a result. In this regard, the Fed has indicated it will tolerate an overshoot in inflation without changing policy as it sees an expected rise in prices as temporary.
US yields are rising for a combination of the following:
- Expectations of stronger economic growth
- Expectations of higher inflation
- Prospect of a never ending and increasing supply of government bonds
Under normal circumstances, markets would anticipate a Fed tightening preceded by a tapering of bond purchases, but the central bank seems in no rush to do so. This complicates a reaction to higher bond yields as it comes from a steepening in the yield curve and not by expectations of a Fed rate hike.
Looking ahead, much will depend on what the market chooses to focus on.
- If it accepts the Fed’s view that higher inflation is temporary, the bond market should trade orderly.
- If it sees the Fed as falling behind the curve, then look for volatility and bond yields to shoot higher.
- If the focus turns to the endless supply of treasuries and mammoth US funding needs, then the risk of the bond market reaching a tipping point becomes the risk.
Of this list, a risk of the latter seems to be farther out in the future but could depend on what policies are pursued by the Biden administration and whether the lassez faire attitude towards deficits continues. I address the risk in If, When the Bond Market Tipping Point Would Crash the Dollar?
In the meantime, the prospect of strong growth this year as the pandemic eases, which will be given a booster shot by the about to be passed $1.9 trillion stimulus package, should keep U.S. bond yields elevated. At a minimum, this should provide support for the dollar, especially against lower yielding currencies such as the JPY, CHF and EUR. However, it would be easier to make a call if the 2-year note was joining in so keep an eye on it if forecasts for strong growth and higher inflation prove on target.
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