“What’s up with the dollar?” has been the recurring question for investors lately as the reserve currency has slipped from a 14-year high set at the start of January.
The answer may lie in the link between the dollar and real yields, a proxy for how investors in the bond market view prospects for stronger economic growth and the normalisation of interest rates.
Whereas nominal yields give investors their level of returns on maturity, real yields tell them what those investments are really worth because they take account of inflation. And with US inflation hitting a five-year high, real yields are coming under close scrutiny from dollar-watchers.
In the wake of Donald Trump winning the US election, the real 10-year Treasury yield climbed to a 2016 high of 0.74 per cent by mid-December. It has subsequently retreated since to about 0.4 per cent, and weighed on the dollar.
Real yields have been bothering Société Générale’s forex and fixed-income strategist Kit Juckes for some time. Measuring the dollar’s performance against the yen and the euro alongside differentials in 10-year inflation-linked securities, Mr Juckes sees clear correlations over recent years.
1. Eurozone crisis sparks fears of euro break-up
2. Greek crisis sets off another round of eurozone angst
3. Trump election drives reflation trade and dollar rally
4. Trump presidency sows investor doubts about US growth
5. French election worries drive down German bond yields
“A sustained or significant push higher by the dollar from here probably requires US real yields to move towards 1 per cent,” he says. Since 10-year real yields have averaged 1.8 per cent in the past 20 years, and in a climate of continuing gross domestic product growth and rate normalisation, “real yields ought to be able to get to 1 per cent”, he adds.
So if the dollar is softening because of declines in real yields, what is causing them to weaken?
Steven Saywell, G10 forex strategist at BNP Paribas, identifies a strong link between the euro-dollar exchange rate and US-EU real yield differentials, but says that the link has been breaking down this year despite expectations for stronger growth and higher interest rates set by the Federal Reserve.
“That could be about Donald Trump threatening tariffs or punitive measures,” says Mr Saywell.
It is not the first time that geopolitical tensions have created a dollar-real yield disconnect, Mr Saywell adds, citing the 2011 eurozone and 2015 Greek crises. “We could be going through a similar period with Donald Trump and fears of trade wars,” he adds.
Or other factors may be coming into view. French election worries this week pushed the relationship between US and German two-year government yields to their largest divergence since 1999. At the same time, eurozone policy is dovish while inflation expectations are rising, which means eurozone real yields are negative.
Still, signs of a slowing in the hectic pace of the nascent Trump presidency, including a possible reassessment of a border tax, may be giving the dollar a positive tinge, as well as anticipation of Mr Trump’s State of the Union address to Congress next week.
All this points to likely higher real yields, giving further cause for optimism for dollar bulls. Citigroup, which says that over longer periods US real rates “seem to matter”, has noticed a rise in expected long-term real interest rates following a noticeable dip last month.
The key metric to watch is the pace of inflation, since this guides investors to the likely level of real yields. What matters is not just whether US Treasury 10-year yields are rising but where they sit in relation to inflation.
At 2.4 per cent, 10-year yields are below inflation, says Mr Saywell, “so if you have got inflation rising faster than 10-year yields, that would suggest the Federal Reserve is a bit behind the curve”.
For the moment, the Fed is relaxed about the level of inflation. Minutes from its last meeting, noting that policymakers expected a further rates rise “fairly soon”, also expressed the view that there was only a “modest risk” to a significant uplift in inflation.
It is perhaps a niche debate whether investors should follow real or nominal yields to determine the dollar’s direction. The nominal 10-year Treasury yield has this year been stuck at about the 2.4 per cent level, reason enough for investors to pause on dollar-buying.
And some caution against focusing too heavily on real yields. Steen Jakobsen, chief economist at Saxobank, says it is the inflation differences between countries rather than real yields that best guide him on dollar exchange rate moves.
Marc Chandler at Brown Brothers Harriman says the dollar’s correlation with nominal 10-year yields is more robust, simpler to calculate and one that asset managers follow.
But Steven Englander at Citigroup says real yields have “a decent, albeit inferior correlation” with the euro-dollar exchange rate. In a year when inflation will grab attention, it may well be a key gauge for the dollar’s destiny.
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