It has been a while since yields mattered much for the dollar, with so much focus on leveraging and deleveraging trends that macros and algos have been plugged into with the rest of the market playing along, but today”s surge in Tsy yields is a reminder to the market that yields still matter, particularly inflation-adjusted yields. If the US can produce higher yields without a commensurate rise in inflation, the dollar will benefit particularly well if US yields rise faster than those of most competing currencies.
Historically the correlation between the levels of the daily deutschemark-dollar rate and interest differentials since 1977 (when data is first available) is a strong 0.72. Over the last 32 years, long periods of positive correlation have been punctuated by 5 episodes of negative correlations, including the present one. These episodes averaged 10 months in duration and we are in the 10th month of the present one. Considering rate differentials as an anchor suggests a fair value for EURUSD of 1.20 presently. The residual from this relationship, a measure of the rates-adjusted risk premium on the dollar, have been driven significantly by oil prices and the VIX.
Key negatives for the dollar with recovery are higher oil prices and capital outflows on improvements in risk appetite. As oil prices have again run up well ahead of reasonable forecasts of recovery the risk/reward on this “vehicle” points to the downside. On risk appetite, equity volatilities have fallen below average recession levels and should drift down with recovery.
It is very likely that rate differentials will re-emerge as a key driver of the dollar and that a gradual global recovery as economic forecasts will continue to push rate differentials in favor of the dollar.
