Market Analysis: Rates Fall While The Dollar Gets Stronger

Disconnect between US rates and USD One of the mysteries of the financial markets nowadays is the disconnect between US interest rates and the direction of the USD. Interest rates have been falling and falling – 10-year yields peaked at the end of last year at 3.03% and are now down to 2.43%. Fed Funds expectations have fallen dramatically as well, not just from their peak last September (down 100 bps) but even from their level at the beginning of the month, before the better-than-expected nonfarm payrolls came out (down 31 bps). Yet the dollar has gained 0.9% over the month, as measured by the DXY Index . Usually, higher interest rates pull a currency up and lower rates push it down. What’s going o

Part of the dollar’s strength is no doubt due to the weakness of the euro. The ECB’s apparent resolve to loosen policy further, including instituting negative rates, is helping to boost the dollar. But it’s not only that – USD is up in May against most other G10 currencies, including 1.6% vs CHF, 1.0% vs NZD and 0.6% vs GBP (although it’s down vs JPY, CAD and NOK). One reason is that with European yields also declining, Treasuries retain a healthy (although narrowing) yield advantage. Also, the dollar is following the better US economic news – it’s been rising more or less in parallel with the economic surprise index, a measure of how far indicators exceed or fall below expectations.

But if positive economic surprises are helping to support the dollar, then they should also be pushing Treasury yields higher, not lower. Morgan Stanley explained yesterday’s Treasury rally by saying “positioning was again the prime suspect in this latest in a run of seemingly out-of-the-blue rallies in recent weeks.” They say the recent rally has been due to a shift out of “net short/underweight positioning established earlier in the year as investors anticipated an impact on yields from stronger growth, QE tapering…and looking ahead to Fed rate hikes that certainly hasn’t happened to this point.” Bond on both sides of the Atlantic also seem to be affected by recent comments by officials, including former Fed Chairman Ben Bernanke, that the terminal level of policy rates when policy is finally normalized is likely to be well below the historical average. European bonds have been rallying on expectations of further ECB easing, and with US yields higher than Bunds, they remain attractive to foreign investors. Finally, looking at the decline in Treasury yields as US stocks extend their rally into record territory, the US markets may be forecasting a Goldilocks scenario of strong yet non-inflationary growth. It’s possible. Japanese 10-year yields haven’t been above 2% since February 1999.

In any event, the dollar continued its gains overnight, rising against all the G10 currencies except JPY and AUD (see below). EUR/USD broke below the 1.3612 level that has provided support until now, which suggests that USD is likely to continue to gain (see technical comment below). It even gained vs GBP despite comments by Martin Weale, an external member of the Bank of England’s Monetary Policy Committee (MPC), in a Financial Times interview that rates would have to start rising earlier than expected and could rise by up to one percentage point a year, faster than the market currently anticipates. The failure of GBP to respond to these comments suggests sentiment towards the pound has changed significantly. The technical picture has also turned poor (see below). I am becoming more cautious on the currency.

Overnight news: Overnight Japan announced that retail sales for April fell at a record 13.7% mom, exceeding market estimates (guesses, really) of an 11.7% mom decline. Nobody really had any idea how much demand would fall off after the consumer splurge in March, ahead of the April 1st hike in the consumption tax. Now we will be waiting to see how long it takes for demand to bounce back to normal. One might have thought that the larger-than-expected decline would depress the yen as it makes further BoJ easing marginally more likely, but the currency was strengthening before the news and didn’t really react to the report.

Australia’s private capital expenditure fell 4.2% qoq in Q1, far more than the -1.5% the market expected, but the market focused instead on the forward-looking news, the spending plans for FY14/15. These showed a rise of AUD 12.2bn from the previous estimate to AUD 137.1bn, “well above” expectations. The key point was that this rise was due to increased investment intentions of the services sector, suggesting that other industries may be able to take over from the mining industry as the engine of growth for the Australian economy.

Today’s indicators: There are no major European indicators coming out today. On the other hand, there are several important US indicators coming out. The second estimate of the nation’s GDP for Q1 is forecast to show a 0.5% qoq SAAR decline after the initial estimate of +0.1% qoq SAAR growth. The contraction in output will probably be attributed to cold weather. The slowdown to +0.1% qoq SAAR growth caused the dollar to weaken somewhat, so news of a contraction could have an even bigger impact, but on the other hand, the second estimate of GDP usually does not have as strong an impact as the initial impact, since by this time Q1 ended almost two months ago and the Q2 data has been shaping up fairly well. Initial jobless claims for the week ended on May 24 are estimated to have declined to 318k from 326k the previous week, bringing the 4wk moving average down to 316k from 322.5k. Finally, pending home sales for April are expected to slow.

As for speakers, Cleveland Fed President Sandra Pianalto gives welcoming remarks at a conference entitled “Inflation, Monetary policy and the Public”.

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