The US dollar just doesn’t seem to be getting a break this year. Monday market activity showed the dollar finally rising, however, on Tuesday, it was back to struggling.
The general assumption is that when a country’s central bank raises interest rates, the currency tends to strengthen. And when that happens, foreign exchange buyers flock towards the strengthening currency. The idea is that the speculators will be followed by investors. Investors will help grow the economy, etc., etc., etc.
The Federal Reserve Bank of America has raised interest rates 3 times since Donald Trump became president. Despite that, the dollar slipped to a 33-month low. The ICE Dollar Index (DXY) measures the greenback’s performance against 6 of its major competitors – the Euro, the Yen, the Pound, the Canadian Dollar, the Krona and the Swiss Franc. This index has dropped more than 10% this year and last week, the dollar hit that 33 month low. Inflation in the US, despite a stable, growing economy has stayed stubbornly low.
Some analysts have blamed the Trump administration for the slump, averring that his failure to keep campaign promises for economic growth is affecting the dollar. However, Simon Derrick, Chief Markets Strategist, BNY Mellon London, has something else to say.
According to him, the metric to note is the yield spread between the 2-year Treasury note yield and the 10-year Treasury note yield. The spread between these two has often followed the dollar. Historically, when the yield spread between these two notes narrowed, it tended to indicate lower expectations of inflation. This would mean the demand for longer term bonds was increasing, thereby pushing down on yields. A prime example of this is the dollar’s tailspin after 2002.
Derrick avers that he is now observing a similar trend. Inflation was expected to rise after the election. Yield spreads started increasing on expectations and “reflation” trade. This, however, scared investors, who started selling long term Treasuries. They felt that Trump’s pro-business plans to grow the US economy could cause a steep rise in inflation. Then, as there were no major upsets or new plans carried out in the subsequent months of Trump’s presidency, started steadying at a high, topping the 2% target by early 2017.
Then, inflation started slowing down – deflating after the initial euphoria of the elections. The 10-year Treasury dropped to a 10-month low. The combination of a sharp rise in short-term rates and the expectation that the Federal Bank would raise interest rates again caused the yield curve to flatten. Correspondingly, the dollar also dropped in value.
Furthermore, Derrick warns that the curve could continue to flatten some more. If the Federal Bank keeps raising interest rates to increase inflation, then the markets start getting nervous about the risk of a policy mistake. According to him, the threat to the USD is growing, not reducing.
Another reason why the dollar dropped on Tuesday, despite signs of resurgence on Monday, was the sudden, sharp and unexpected rise in inflation in the UK. The pound sterling hit its highest level against the US dollar this year. The reports of a spike in inflation in the UK has investors expecting the Bank of England to raise interest rates sooner than expected. The pound shot up to $1.3283 during the intraday trading before settling at $1.3272 after the Office for National Statistics announced that inflation had gone up by 2.9% in August. This was higher than the analysts’ prediction of 2.8%.
As a result, the ICE US Dollar Index went down by 0.1%, to close at 91.85.