Has the US Dollar Bottomed? And Do Bond Yields Hold the Answer?

06/05/2009 12:01 am EST

Focus: FOREX

Traditional financial theory tells us that a country's bond yields have direct impact on that country's currency. For example, a rise in US yields should be supportive for USD because higher returns should attract foreign capital inflows. The charts below show that widening in the US and European bond yield spread came in line with USD's rise against the euro until late-April/early-May, while positive correlation between US treasury yield and USD/JPY broke down in the past two months. What's wrong with the US bond market, or is there something abnormal in the currency market?

The US ten-year government bond yield has picked up rapidly in the previous month and risen to 3.75% on May 28—the highest level since November 28—despite success in the Treasury note auctions. We believe the simultaneous selloff in USD and Treasury bonds signaled an increase in risk premium demanded by investors to own USD-denominated assets so as to compensate for the increased currency risk.

The Fed's QE policy is funded through printing money and is inflationary in nature. Worries about rapid surge in the US budget deficit have loomed due to the massive credit easing policy as well as an increase in government spending. We have to realize that issuance of Treasury debt is not an occasional event, but will be performed persistently as the government needs money. Investors' concerns about oversupply in Treasury debts are negative for both bond prices and USD.

Although the Fed's purchase of securities may help stabilize yields, it creates a dilemma in the current situation. The Fed's purchase can cap bond yields, however, at the same time, it reduces attractiveness of US Treasuries to foreign investors as return is lowered, causing further weakening in USD. In that case, commodity currencies such as AUD/USD and NZD/USD would benefit as they have the highest sensitivity the dollar's weakness.

On the other hand, if the Fed does not intervene and let the market determine the yields, it will threaten economic recovery. The Fed's inactivity would cause an increase in yields and mortgage rates, which will put the seemingly bottomed housing market in jeopardy. Although higher rates may help USD, it would be harmful for the economy.

The Fed will likely try to get the balance, but we are skeptical about the success given the huge US Treasury market. It's hard to monitor the supply and demand issue so as to hold both yield and USD well.

While some analysts on the street start to call for a bottom in USD after a severe selloff over the past month, we tend to believe in further weakness after recovery. As the market has become more worried about sovereign risk in the US and the US government will keep both fiscal and monetary policies expansionary for an extended period of time, investors' demand for higher risk premium to own USD-denominated assets should continue in the medium term. Hence, the phenomenon whereby increases in US bond yield and decreases in USD occur together is expected to persist for some time. The Fed's QE policy is funded through printing money and is inflationary in nature.

By ActionForex.com Staff

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