Making sense of the weak USD – Westpac

The USD’s inability to capitalise on higher yields remains a key talking point and the decoupling between EUR/USD and the bund-treasury spread has been apparent for some time but it has gone into overdrive in 2018, explains Richard Franulovich, Research Analyst at Westpac.

Key Quotes

“Between 2012 and 2017 the euro’s relationship with yield spreads was mostly orthodox. In each calendar year the euro rose on average on those trading sessions when yield spreads moved in its favour and vice versa.”

“The magnitude of the euro’s gains/losses vis-a-vis yield spreads shifted around year to year – in some years the euro was more or less sensitive to yield spreads - but overall the relationship was relatively stable and symmetric.”

“So far in 2018 the relationship has completely inverted – on those trading days when yield spreads have moved in its favour EUR/USD has on average fallen while on those days when yield spreads move against it the currency has risen.”

“It has been noted that stronger global growth and the far more mature stage of the Fed tightening cycle relative to other parts of the globe may be weighing on the USD. These are not completely satisfying explanations.”

“If global growth upgrades and the prospect of a lot more policy normalisation in the rest of the world over the next couple years vis-à-vis the US were key drivers then these trends should be showing up in yield spreads too – but of course they are not.”

“Given all that we are left with the impression that the prospect of material red ink in the US fiscal accounts - thanks to the Republican tax plan and the $300bn two year budget agreement - have been a key factor behind USD weakness.”

“Barely six months ago the CBO was projecting US public debt at 91% of GDP by 2017. In the wake of tax cuts and assuming the two year budget plan is extended for ten years US public debt is now on course to hit 105% of GDP, a marked deterioration. That certainly helps make sense of the inverse relationship that has emerged between yields and the USD.”

“A closer look at US yields adds to the impression that a risk premium has emerged. From the Sep 2017 lows in US yields through to year’s end the 10yr yield rose about 35bp. That move was overwhelmingly due to rising Fed hike expectations. Over that same period the 10yr term premium fell.”

“So far in 2018 the drivers have completely flipped – the US10yr yield has risen about 52bp with 36bp (or about 70%) coming from a higher term premium, while Fed hike expectations embedded in the 10yr yield have only accounted for a comparatively smaller +16bp to the overall increase.”

“In short, Fed expectations drove nominal 10yr yields higher in late 2017 but in 2018 a risk premium, probably a combination of inflation and fiscal risks, has accounted for the bulk of the rise in yields. Not coincidently, the USD rose in Q4 last year but has fallen this year.”

“With the benefit of hindsight its clear US deficits have long driven the US yield curve and the USD.”