Federal Reserve interest rate increases and increasing supply last week helped send benchmark 10-year bond yields to seven-year highs.
Day to day, higher yields are cited as boosting the U.S. dollar as capital flows into the country to seek out the higher rates. But that correlation does not hold up in the longer term, with higher yields instead being a drain on the currency.
“History shows that if we are still in this upward-moving yield environment, that could continue to have a negative feedback loop into the dollar,” said Tom Fitzpatrick, chief technical strategist at Citigroup in New York.
The dollar index <.DXY> is down around 8 percent from a 14-year high in January 2017, and has climbed off three-year lows set in February.
With the Fed expected to continue raising rates and the United States projected to almost double its debt load held by the public to $29 trillion in the coming decade from $16 trillion today, further weakness in bonds and the greenback is likely.
In the past 30 years or so, the dollar has almost always weakened when there have been major sell-offs in fixed income. This includes in 1987, in 1994 and from 2004 to 2006, when in each case the bond market weakened as the Fed raised rates.
(Dollar yields:
The “taper tantrum” of 2013, when the Fed said it would reduce bond purchases, also sent yields higher and hurt the dollar, while yield increases on Fed rate hikes since late 2016 have weighed on the greenback.
(Dollar vs. Yields:
An exception was from 1998-2000, when the United States had a fiscal surplus, leading to expectations of debt paydowns, and immediately after the introduction of the euro.
Conventional wisdom says that U.S. monetary tightening automatically produces a stronger dollar, but in fact Fed rate hikes are usually associated with dollar weakness, said Anatole Kaletsky, chief economist and founding partner at Gavekal in London.
“Periods when the U.S. interest rate is going up, when the Fed is tightening, are almost by definition periods when the expected rate of return on capital in the U.S. is going down relative to the rest of the world - and that means long-term capital will flow out of the dollar," Kaletsky said.
Indeed, U.S. flow of funds data show that foreign purchases of Treasuries often decline as yields increase.
(Dollar bond yields:https://tmsnrt.rs/2OtKoag
The greenback was bolstered at the outset of quantitative easing as the United States took the first steps toward repairing its economy after the financial crisis. As other regions such as the Eurozone get closer to rate increases, the relative opportunities may shift in Europe’s favour.
Still, not all analysts view Fed rate rises as negative for the greenback, and see dollar strength as having further room to run.
"To me the game changer is when the U.S. economy starts to soften and the Fed has to think about cutting rates," said Win Thin, global head of currency strategy at Brown Brothers Harriman in New York.
A Reuters poll of currency strategists earlier this month found that it could be another six months before the dominant dollar strength trade is swept aside.
GRIM OUTLOOK
Worsening deficits and higher debt needs also make investment in the United States less attractive even as economic growth is solid, adding to pressure for higher yields.
The U.S. current account deficit reached 2.5 percent of gross domestic product in the first quarter, a level at which typically “the dollar starts to respond negatively,” said Bilal Hafeez, global head of G10 foreign exchange strategy at Nomura in London.
Further dollar weakness would fit with the longer-term trend that has been in place since the end of the Bretton Woods system in 1971.
It is also in line with some beliefs that the United States is at the end of a 30-year bull run for bonds, with yields recently having broken out of their long-term downtrend.
Assuming that the greenback reached an interim peak last year, it now faces an additional five or six years of weakness, based on its long-term bear trend, said Citi's Fitzpatrick.
“What we’re seeing here is not an episodic moment of dollar weakness but in our view more likely an extended multiyear period that is going to see the dollar significantly lower than where it is today,” he said.
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Hafeez sees the euro gaining against the greenback to around the $1.40 area against the euro in the coming years, from $1.15 now, while Kaletsky sees a decline to around $1.30-$1.35. Fitzpatrick sees a more bearish picture, with a decline to the $1.80 area by 2024.
(Reporting by Karen Brettell; editing by Jonathan Oatis)
By Karen Brettell
