For currency traders looking to determine the dollar’s direction, the Treasury yield curve may hold the key, and bulls should be worried, according to Bank of New York Mellon Corp.
The correlation between the Bloomberg Dollar Spot Index and the gap between the U.S. 2-year and 30-year yields has strengthened for the past month, peaking near highs last seen in June 2017. Ever since emerging markets swooned in mid-August, a flattening of the yield curve has fed through to greenback weakness, the bank said.
“It looks as if the FX market and the U.S. Treasury market are now both quietly responding to concerns about how long the current U.S. economic cycle has to run,” Simon Derrick, chief currency strategist at Bank of New York Mellon, wrote in a note. “It’s also possible that investors are becoming concerned at the margins over how the trade war tensions will impact this.”
Confidence about the outlook beyond 2019 “is nowhere near as strong” as it is about what the Federal Reserve will do next year, Derrick wrote. The spread between fed funds futures expiring in January and December 2019, which reached a record 46 basis points this week, reflects a high degree of certainty about rate increases.
The dollar has risen more than 5 percent since mid-April, buoyed by robust U.S. growth, monetary tightening and haven flows amid an escalation of global trade tensions. The prospect of rising inflation and Fed staying on its gradual path of monetary tightening pushed the yield curve last month to the narrowest since 2007.
“Given the relatively modest scale of yield support when compared to headline inflation rates, this leaves the USD looking potentially exposed,” he said.
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