A daily summary and commentary of events and factors that affect the global markets, with a particular emphasis on the foreign exchange markets.
Goldilocks Growth No More
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Andrew Kositkun Senior FX Advisor
Market price action continues to challenge the previously held assumption of a sustainable goldilocks environment where robust growth could be had with little or no consequence for inflation or central bank policy.
In reality, the prospect of higher U.S. yields has always been a potential source of support for the dollar. So while this past week’s rise in yields was more of a global phenomenon, the argument for U.S. yields to lead the move higher due to the relatively smaller U.S. output gap and larger fiscal stimulus plan remains in place. With expectations growing that the next round of U.S. fiscal stimulus will be closer to the proposed $1.9 trillion mark and expectations for a multitrillion-dollar follow-on infrastructure package, the narrative of U.S. economic exceptionalism and U.S.-led upward yield pressure should remain a key first-quarter market narrative. Given this focus on rising yields, at what point does the market transition from welcoming reflation expectations as a sign of a strong recovery to having concerns over consequences for monetary policy and how central bank policies may differ?
The short answer to this question appears to be very soon. Historically, the U.S. dollar has a negative correlation with yields over the longer term. This is due to the dollar’s anti-cyclical qualities. As the global economy falters, yields fall, and demand for safe-haven assets, such the U.S. dollar, increases and vice versa. However, this relationship isn’t a stable one, with the dollar’s relationship to the movement in yields flipping to a positive one once yields rise pass a certain level, as higher yields flip to a support factor.
In an effort to understand where this level might be, an analysis was done that normalized yield levels and determined threshold points relative to recent norms and not long-term averages. In theory, this should account for absolute yield levels that are still historically low and focus the analysis solely on the recent momentum in yields. The upshot for all of this is that U.S. yields are around the area where the U.S. dollar’s relationship with yield movements historically flips from negative to positive, as seen in the mid-2000s, the 2013 taper tantrum and during the most recent period of U.S. economic exceptionalism.
Beyond the overall dollar trend, a similar dynamic exists in which the breadth of the dollar’s move against individual currencies grows as yields rise. As such, the U.S. dollar is likely to not only become more sensitive to U.S. yields if they continue to rise but also to appreciate against a large proportion of currencies as well.
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