The dollar's weakness in the face of three interest rate increases last year and bond yields hitting near decade highs is baffling and may be due to both short-term uncertainty and long-term pessimism, according to analysts at BNY Mellon.
Last year was supposed to be the year of the U.S. dollar, with the Federal Reserve delivering three planned rate hikes and the 2-year Treasury note yield rising to 1.9%, its highest level since September 2008.
The ICE Dollar index a measure of the dollar against six major rivals, settled at 91.85 on the last trading day of 2017, down 10% for the year--its biggest calendar-year decline since 2003. The euro , its biggest rival, rose 14.1% in 2017.
The weakness of the greenback in light of a strengthening economy and a robust stock market rally might seem even more surprising.
Neil Mellor, senior currency strategist at BNY Mellon said that in an environment in which markets have long been distorted by years of ultraloose monetary policy, it is difficult to pick out the causes of a weaker dollar.
"When the dollar rises along with the short-dated Treasury yields, there is a clear explanation for such a move. But that connection has broken down and it's hard to say if it means anything," Mellor said.
"It is quite possible the dollar, just like the shape of the yield curve, is telling us the long-term future is negative. But it is also possible traders are selling dollars because they are uncertain about the short-term future and when people are uncertain they sell," Mellor said.
The U.S. Treasury yield curve--the difference between the short-dated and long-dated yields--has been flattening steadily since 2013, when it was at about 265 basis points. The spread between the two-year and 10-year Treasury yields is currently at 53 basis points, roughly where they were in 2005, before eventually inverting.
See:Why this U.S. recession signal is probably throwing off a false alarm (http://www.marketwatch.com/story/why-this-us-recession-signal-is-probably-throwing-off-a-false-alarm-2017-11-18)
An inverted yield curve preceded all of the past seven recessions, but a flattening yield curve does not always mean it will invert. If economic growth accelerates and inflation expectations increase, the yield curve could steepen.
The euro's strength against the dollar last year cannot be explained by rising German bund yields--which rose across all maturities--alone, either. However, the increase in bund yields should be taken in the context of yields that remain negative up to four years, while the 10-year benchmark yield rose only 10 basis points in all of 2017.
Simon Derrick, also a currency strategist at BNY Mellon, argued in a note that the issue may be due to very long-term bearish views among investors.
Derrick analyzed the spreads between U.S. and German bond yields across all maturities, comparing them to the euro/dollar pair.
He found that the normally tight relationship between short-dated spreads and the euro broke down some time in May 2017, even turning negative at one point. Meanwhile the correlation between 30-year US/German spreads and the euro tightened, as shown in the chart below:
"To highlight how extremely unusual this situation is, it's worth noting that the correlation between the two-year German/U.S. government bond yield gap is now at its lowest since 2005, while the correlation with the 30-year remains at extremely high levels. Looking back over the history of the euro, at no point has this happened before," said Mellor.
Indeed, the correlation between 30-year German/U.S. bond yield spread and the euro is above 90%. Long-dated bond yields usually signal expectations for long-term inflation and economic growth.
"This implies that the dollar's muted performance is a reflection of growing pessimism about the growth/yield environment beyond 2020," Derrick said in a note.
While the BNY Mellon analysts refrain from making recession calls, they expect the dollar to continue to weaken against the euro and the British pound over the next few months.
"We will be watching economic data for signs of acceleration. In the meantime, the momentum and technicals indicate the weakness is likely to persist," Mellor said.
(END) Dow Jones Newswires
January 04, 2018 11:18 ET (16:18 GMT)