Forget The Fed: The Long Bond Is Deciding The Dollar's Future
November 20 2017 - 12:59PM
Dow Jones News
By James Mackintosh
The foreign exchanges have a message for central bankers: the
short-term interest rates they set aren't the big deal they once
were. After more than $12 trillion of quantitative easing
world-wide, currency markets are now more sensitive to the
gyrations of the long-dated bonds vacuumed up by the central banks
-- and that makes them even harder to predict than usual.
The change comes at a delicate time for central banks, with the
U.S. tentatively cutting its holding of Treasurys and mortgage
bonds by $10 billion a month and the European Central Bank about to
taper its bond-buying program. A currency market more focused on
long-dated bonds gives policy makers less control over exchange
rates and domestic financial conditions than usual, just at a
moment when they want to keep a firm grip to avoid upset.
In the past it was short-term interest rates -- and the two-year
bond yield, which reflects near-term anticipated rate changes --
that were most important for major currencies. The more interest it
was possible to earn in a country, the more money was attracted,
and the more the currency went up. The extra yield available on
U.S. two-year bonds above German two-year bonds, for example, was
typically tightly correlated with moves in the dollar-euro exchange
rate.
There are at least two really good reasons why this should be
causal, not merely chance correlation. First, money flows. Higher
interest rates attract short-term speculative cash chasing what
traders call "carry," the extra interest available in one currency
over another. Second, fundamentals. Higher rates are a sign that an
economy is doing better or inflation is rising, both of which
justify a stronger currency, at least in nominal terms.
The logic has broken down this year for both flows of money and
fundamentals, and the year-to-date correlation between 10-year
yield differentials and the dollar's value against each of the
euro, yen and sterling hit the highest since at least the early
1990s in September.
Japanese and European investors have been buying longer-dated
U.S. Treasurys because of negative interest rates on cash and
short-dated bonds at home, so flows are more sensitive to long bond
yields than in the past. At the same time, central banks are
suppressing the usual reaction of economic fundamentals. The ECB
has promised not to raise rates for a long time, even as the
eurozone economy is growing at its fastest pace in five years. That
means speculation about economic fundamentals moves longer-dated
bonds a lot more than short-dated bonds, and in turn moves the
currency.
"The short-term [rates] differential contains less information
because you essentially have stability of short-term rates in
Europe," says Amundi fixed income and foreign exchange strategist
Bastien Drut in Paris. Instead, the German 10-year bund swung about
as bets on the ECB reacting to a stronger economy by pulling back
from its bond-buying program ebbed and flowed -- and the euro's
value against the dollar moved with it.
Even during the rally in the dollar in the past two months the
focus has stayed on long bonds, as 10-year Treasury yields rose
more than those on Germany's bunds, which are still well below
their July high for the year.
The focus on long bonds helps explain why many traders were
caught off guard by the plunging value of the dollar this year,
when the currency disconnected from its usual tie to short-term
yields. The dollar dropped even as the Federal Reserve raised the
overnight policy rate twice, with a third raise expected next
month. What mattered instead was the 10-year Treasury yield, which
plummeted from 2.5% in late December to a low of 2.05% in
September, even as German 10-year bond yields picked up and
Japanese yields did almost nothing.
Technically the major central banks should care little about the
currency, with policy about the dollar the preserve of the U.S.
Treasury and the ECB targeting inflation, not the exchange rate. In
practice a stronger or weaker currency can have dramatic effects on
how tight monetary policy is, neutralizing or exaggerating the
effects of changes in interest rates.
This year the Fed's efforts to tighten monetary policy have been
undone by the weaker dollar and lower 10-year yields, which
supported booming credit and equity markets. The U.S. has the
loosest financial conditions since 1993, according to a measure
compiled by the Chicago Fed, despite two rate rises. Back in 1993
bond differentials were strongly tied to the value of the dollar,
although back then short-dated bonds mattered more.
With inflation still below target, the Fed hasn't been that
bothered by the failure of its interest-rate policies to bite. If
that changes, 1993 was a past that would make an unpleasant
prologue: the following year the Fed seized control with surprise
rate increases that shocked investors, pushing up bond yields and
breaking their link to the dollar entirely.
Write to James Mackintosh at James.Mackintosh@wsj.com
(END) Dow Jones Newswires
November 20, 2017 12:44 ET (17:44 GMT)
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