FYI | Jan 15 2015
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
Apart from the collapse across commodity markets, the other news that investors had to digest today was the fall in Treasury yields. The 30-year yield fell to its lowest ever level. Disappointing retail sales from the US was the trigger, and the decline in yields was broad-based. The 10- year yield also fell to 1.82%, a mere 20 basis points above its record low, and even the 2-year yield nose-dived, and is now 30 basis points lower than where it was at the end of Dec.
The market is rapidly pricing out the prospect of a rate hike from the Federal Reserve. Although FOMC member and noted hawk Plosser advocated for a rate hike to normalise policy during a speech today, Plosser is not a voting member of the FOMC this year so you could argue his view doesn’t matter. The market seems to expect a dovish shift at the Fed later this month when we will hear from its newest members at the next FOMC meeting at the end of January.
Yields and FX
Yields can be a big driver of a currency, and the dollar nose-dived on the back of the disappointing retail sales data and the decline in the 30-year yield. However, as we move to the end of the London session, the dollar index (the dollar vs. its largest trading partners) has been in recovery mode, suggesting that one poor retail sales report will not keep the dollar down.
If you look at the dollar and long-term US yields on a chart, as you can see below, you can see that something interesting is going on. The dollar seems to have diverged from Treasury yields, with the dollar still acting like the Fed is about to hike rates, while the Treasury market is rapidly pricing out the prospect of rate hikes in the first half of this year.
So who is right?
This is difficult to answer, so I have come up with a few of scenarios:
1, Either the dollar follows yields lower in the coming weeks, and 92.52 in the dollar index– a 12 year high, is a top in the dollar for now.
2, The dollar and yields move in synch once again. This may be triggered by a hawkish Fed, stronger than expected CPI on Friday or better growth signals, which causes a reversal in Treasury yields at the same time as the dollar rallies.
3, This market falls into panic mode fuelling inflows into the Treasury market, weighing on yields while pushing up the dollar.
Is the market really in panic mode?
I have trouble with the third scenario. A stronger dollar / weaker Treasury yield tends to be a sign of market panic – and although the market is jittery, I would argue that we aren’t in panic mode in the West just yet. For example, the Vix is at 22, below its peak of 2014 when it reached 26.
We aren’t in the middle of a currency crisis, the Fed is only thinking about raising rates by 25 basis points (hardly a drastic move), and as long as you are not in Russia then you are unlikely to be experiencing a financial panic. Even Greek bond yields have fallen today and we are less than 2 weeks from a Greek election.
A new regime for the FX market?
This could be the new regime for FX markets. The landscape has changed, deflation is taking hold all over Europe, growth is slowing for energy exporters and the US looks like the best bet. Thus, a stronger dollar combined with weaker yields may not be a precursor to financial crisis, instead it may be a sign that the US (and thus the dollar) looks like the best bet out of all the global economies, and potential risks such as the collapsing oil price and Russian financial woes, continue to drive inflows into Treasuries, which drives down yields.
I could be wrong, the dollar / yield dynamic could be a signal that the world expects a wave of defaults from the oil producers, but for now at least that does not seem to be a problem.
The FX view:
To conclude, this is a strange new world. In the past we would have looked for broad-based dollar weakness when yields fell so sharply, but these days you can’t bank on that relationship being maintained.
If you are trading the dollar right now, we would urge caution until we see a significant break above the recent high in the dollar index at 92.52. If the bulls can’t break above this level then it could be a sign that the greenback will follow yields lower in the coming weeks.
Chart 1: The yield/ dollar divergence quandary
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