Five factors why US yields aren’t driving USD - Nomura

Analysts at Nomura offered a laundry list of factors why US yields aren’t driving USD and they remain comfortable holding a bearish dollar view even if US bond yields are rising. 

Key Quotes:

1) The dollar has already rallied too much for a Fed hiking cycle. From 2013, the year of the Fed taper, to 2016, the year of Trump’s election victory, the dollar rallied over 30% on a trade-weighted basis. The dollar clearly took notice of higher US bond yields. In some ways, what is unusual is not that the dollar has recently stopped following US bond yields, but rather it paid too much attention to yields before. During previous Fed hiking cycles the dollar has typically weakened and since 2008, it has far outperformed other currencies, whose central banks hiked. The dollar’s weakness over the past year is likely bringing it back down to its more usual performance in a hiking cycle.

2) Starting a tightening phase matters more than mid-way hikes. One lesson from the Fed hiking cycle was that exiting QE (taper) and early hikes have a much bigger impact on FX than later hikes. The dollar surged against emerging market FX during the taper tantrum and put in its best performance more generally up to the first hike in late 2015. If we apply this to the ECB – this suggests that markets should be much more sensitive to ECB expectations than Fed expectations and correlations bear this out. The fact that the ECB scaled down its QE programme first in late 2016 and then in late 2017 suggests that we are in the zone where the euro will likely be driven by euro bond yields rather than yield spreads. From mid-December, euro bond yields surged higher, coinciding with the latest surge in the euro. This also means Thursday’s ECB meeting could be important for short-term price action in the euro. 

3) US trade deficit is a problem. Typically, when the US trade balance worsens, the correlation between rate spreads and the dollar weakens. This was the case in the early 2000s when the dollar ignored Fed hikes as the current account was worsening (Figure 5). Today, the US trade balance is worsening and the trade surpluses of the euro area and Japan are growing (Figure . This could put even more focus on trade policy in the US. Already, the US administration has imposed tariffs on solar panel and washing machine imports. The US’s trade partners are likely to allow more currency strength to avert a full-on trade war, which further fuels dollar weakness. 

4) Euro winning capital flow battle. Last year, equity flows into the euro area picked up and now it seems bond flows could be supporting the euro. Investors are underweight euro area bonds thanks to scars from the sovereign crisis, negative yields in core markets and political event risk. But with Italian election risk likely to be low and still strong euro area growth, peripheral bonds should be attractive for investors. They have performed well in recent months, which has likely helped the euro. 

5) China matters. It’s often hard to know whether the Chinese yuan is reflecting dollar weakness or causing it. What we do know is that since last year, the Chinese authorities have reversed the rise in USD/CNY and now we are seeing meaningful CNY strength against the dollar. Part of this was likely a response to the election of President Trump and the need to avoid being labelled a currency manipulator. The pace of CNY strength has picked up over the past month, which has coincided with general dollar weakness (Figure 9). Importantly, recent currency strength has not disturbed the domestic growth picture. In fact, Chinese stocks are delivering stellar returns. A reason for this is likely to be the more limited gains of the CNY against other currencies. The Chinese authorities may be attempting to keep a range-bound CNY basket, which would mean ensuring euro (and yen) strength against CNY to offset dollar weakness against CNY. 

As for the risk of a return to US bond yields driving the dollar, we would need to some combination of the following happening: 

1. The Fed departs from the current hiking path to a more aggressive one 2. The ECB delays tightening 3. The US trade balance improves 4. Euro area peripheral bonds stop performing well 5. China stops allowing USD/CNY to fall. "