Coming to grips with the USD – Westpac

Richard Franulovich, Head of FX Strategy at Westpac, explains that yield spreads continue to push relentlessly in the USD’s favour and at +206bp the 2yr DXY weighted spread is at its most supportive levels since 2006.

Key Quotes

“Admittedly the USD has a stronger relationship with long term bond spreads but they are moving just as strongly in the USD’s favour too. Against that, the USD’s responsiveness to yield spreads shifts around a lot over time. And, while the USD’s responsiveness to firming yield spreads is very low at the moment it has been even lower in the past.”

“Regardless, yield spreads may not tell the complete story. Relative growth may be as good if not better a guide. Yield differentials won’t always track growth differentials and the latter can convey useful information about other flows such as portfolio equity flows and longer term direct investment flows. On that score there is a case for a weaker USD. Relative growth is breaking against the USD, at least judging by the OECD’s leading indicators. Allowing for a six-month lag there has historically been a reasonable positive link between the rate of change in the USD and relative growth. But even on this score the USD has weakened more than one might have expected – the broad USD TWI is down about 8% on year ago levels while the OECD relative leading indicators suggest that at best USD momentum should only be slightly negative.”

“Much has also been said about “global reflation” as a source of USD weakness too. There is indeed a tendency for the USD to trade inversely with global growth, regardless of what US growth may be doing. However, this measure does not fully account for USD weakness either. USD’s direction matches the trend in global growth but the scale of the depreciation far outstrips the stronger momentum in the global economy.”

“In short, both absolute global growth and relative growth convey useful information over and above yield spreads and both point to USD depreciation. But, the fall in the USD materially outstrips what outright global growth and relative growth would predict.”

“Prospective USD fiscal deficits may conceivably be playing a bigger role too. The decoupling of the USD with firming yield support has echoes of 2003-2004 when the USD similarly struggled to capitalise on rising yields. Over that period the US economy was well and truly bouncing back from the tech bust - annual average growth was running at 4% by 2004H2 and unemployment was down almost a full percentage point in the year to 2004H2.”

“Yield spreads were also trending firmly in the USD’s favour. But, despite firming growth and falling unemployment the US fiscal accounts were deteriorating, courtesy of the GW Bush tax cuts (enacted in 2001 and 2003). Back then much was made of the fact that the “twin deficits” were hampering the USD’s ability to capitalise on firming yield support. Going forward the US deficit is set to widen sharply thanks to the Trump tax cuts. And, while growth expectations have been revised up courtesy of tax cuts the longer lasting impact is likely to be higher deficits.”

“No one factor seems to fully explain the USD’s poor trend. That said, the combination of potentially larger US fiscal deficits, signs of stronger growth outside the US and firmer absolute global growth could conceivably prevent the USD from benefitting from rising yield support.”