This post was written exclusively for Investing.com
The U.S. dollar may be sending investors a very subtle message about the future of interest rates, both in the U.S. and around the globe. Since the beginning of the year the Dollar Index, which is a basket of currencies used to value the dollar, has quietly risen by about 2%.
It doesn’t sound like much, but one should also consider that during that time interest rates on 10-year Treasurys have plunged by nearly 20 basis points (bps), and the Fed has shifted its monetary outlook to be more accommodative. One would think the dollar should be weakening in this type of easy money environment, but that has not been the case. There may very well be an important reason for that.
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Why Has The Dollar Been So Strong?
The strengthening dollar may be suggesting that investors believe that the European Central Bank and the Bank of Japan may adopt even more accommodative monetary policies in the future, pushing interest rates in those countries even lower than their current levels. It may be one reason why the dollar has continued to strengthen despite the Fed projecting in January no rate hikes for 2019, from prior projections in December of 2-3 rate hikes.
Spreads Contract
The yield on the 10-year U.S. Treasury has fallen to around 2.45% from 3.25% since November 8. The spread, or the difference, of the U.S. 10-year yield and the 10-year German Bund yield, has fallen from 2.8% to around 2.5%. The reason why the spread has narrowed so much less than the 10-year Treasurys decline is that the yield on the German 10-year bund has fallen from around 45 basis points to negative five basis points. Despite rates in the U.S. falling, rates in Europe have fallen as well, and that leaves the spread at a historically wide point. Generally a contracting spread would be expected to create dollar weakness—but this time, it hasn’t, and this may be a signal that rates in Europe still have further to fall.
Dollar May Continue To Strengthen
And indeed, there are signs that the dollar may continue to strengthen as well. The euro has fallen below key levels of technical support versus the dollar at around 1.13. Now the euro is resting on the last level of support around 1.11—should that support level give way, the currency is likely to fall to 1.08 versus the dollar. In addition, the relative strength index is also suggesting that the euro is gaining bearish momentum as it trends lower. Should the euro continue to decline, it may very well be a sign that investors continue to think rates have further to fall across Europe.
Killing Off Inflation
Should the euro weaken further, it will strengthen the dollar even more, which may put downward pressure on commodities that are priced in dollars such as oil and other key natural resources. That would act as a deflationary force across the U.S. economy, killing off any inflation the Federal Reserve was targeting.
In the end, should rates across the globe continue to fall, and central banks continue to ease, it will leave the Fed in a very tight spot. It will force the U.S. central bank to take a decision: either keep rates where they are and risk the dollar continuing to strengthen, thus putting downward pressure on commodities and inflation. Or go along for the ride and start to bring rates down in the U.S. to keep pace with their global counterparts, thus helping to potentially weaken the dollar or at the very least keep it neutral.
This creates an interesting scenario, but also one that should be watched closely. Which way the dollar continues to go may give a very clear picture on the future of interest rates, and could even help add visibility on the stock market and the prices investors are willing to pay.