USD & Rate Differentials: A Breakdown In Correlation; What's Next? - BofA Merrill

USD & Rate Differentials: A Breakdown In Correlation; What's Next? - BofA Merrill

28 March 2016, 21:36
Vasilii Apostolidi
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Rate differentials and relative policy have been a key feature driving the USD since early 2015. However, the strong relationship between the dollar and rate differentials has broken down recently (Chart of the Day) with the USD failing to benefit from a better tone to data since early February—reducing recession concerns—and a significant repricing of Fed expectations. As a result, many have questioned whether the dollar’s rally has run its course with Fed policy normalization fully priced.

In our view, the breakdown in correlation is a reflection of (1) the rise in US inflation breakevens relative to its G4 peers, which pushed real yields lower against the dollar as the efficacy of non-Fed central bank policy has been questioned, (2) the Fed’s continued sensitivity to a strong dollar, and (3) the rising correlation between oil and equities.

We are cautious on the USD near term as the market’s questioning of central bank efficacy could see US real rates outperform as our Rates team believes.

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But we still expect further USD upside ahead as Fed policy normalization progresses. The Fed will not likely want to fall too far behind the curve, so we think real yields will shift to a USD boost once again.

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