US dollar and Treasury yield: a sham marriage

Macroeconomic theory deals extensively with the relationship between currencies and interest rates. For example, interest parity is said to mean that a country’s interest rate advantage must be counterbalanced by an exchange rate adjustment. In other words, a country’s interest rate advantage leads to higher capital inflows, with the currency appreciating and the interest rate advantage thus levelling out. This chain of argumentation („higher interest rates = stronger currency“) is deeply rooted in the collective knowledge of the financial market. And, even if in practice the correlation is far from as close as some believe, there can be no doubt that the currency market is guided by interest rates, especially in periods of strong yield movements. Long-term correlation analyses show the relation between the US dollar index and the 10y yield on US Treasuries to be predominantly positive, albeit quite volatile. For some time now, however, this correlation has been in clear retreat and has now been moving in the region of zero since the end of last year, occasionally even falling into the negative region.

In our opinion, the collapse in the relation between currency and yield is mainly due to the flattening of the US yield curve. The sharp rise in yields at the short end of the curve has made hedging costs for non-USD-based investors extremely expensive. Viewed differently, the net yield that a foreign investor can currently generate in the US Treasuries market (after taking hedging costs into account) is now hardly competitive. The degree to which this development influences the interaction of currency and yield is also revealed by the correlation between the dollar index and 10y yield which is tracking almost exactly the 10y UST-3m Libor spread. In other words, the narrower the spread (i.e. the higher the cost of financing relative to the nominal 10y yield), the less the impact of the yield on the dollar.

The significant increase in hedging costs for foreign investors in the US Treasuries market is therefore noticeably impairing the influence of the yield development on the dollar. Rising (falling) US yields therefore currently have only very limited potential to underpin (weaken) the dollar. As long as the net yield on US Treasuries hardly differs from the net yield on British Gilts, Bunds or even Australian bonds from the perspective of a foreign investor, there is no reason for investors to focus on the US market. This would only change if either the US curve were to become steeper again or the base were to visibly narrow again (which is hardly possible or likely, given the already moderate levels).

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