The most striking feature of the latest USD sell-off is that it is not accompanied by any significant adjustment in the market’s Fed rate-hike expectations.
This is partly because, even after the latest revision lower of median rate expectations in March, the Fed dotplot remains above the rate path implied by the OIS or Eurodollar markets.
In other words, Yellen brought the Fed rate view a step closer to the dovish market view while the latter remained little changed. We further note that the latest sell-off in the USD TWI is in excess of our measures of the relative central bank policy outlook – the spread between the US 2Y rate and the average G9 2Y rate (Figure 5). As also shown, the latest divergence follows a protracted period of fairly close correlation between the two series, suggesting that the USD rally in recent years did not necessarily run ahead of the US rate differential with the rest of the G10.
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One alternative explanation for the USD underperformance in recent weeks focuses on the decline in the US real yields relative to the rest of G10.
In Figure 6, we look at USD TWI and the spread between the real US 10Y yield and the average 10Y G9 yield. That spread has dropped sharply recently and seems to point to a persistent downside risk for USD, especially if – as some clients seem to expect – the Fed slips further behind the curve. That said, the historic relationship between the two series is not as close as in Figure 5. In addition, we suspect that a drop in US real yields should not necessarily encourage persistent outflows from the UST market. Indeed, recent data from the Investment Company Institute suggests that US mutual funds have been reducing their exposure to global bonds (eg, Bunds, OATs and JGBs) while building their exposure to USTs. We think that the flows indicate that ultra-low and falling government bond yields abroad are driving investors into USD-denominated FI assets, despite the apparent drop in US real yields.
We remain USD bulls over the long term. We expect that the improvement in US fundamentals should ultimately push US inflation closer to the Fed’s target and beyond, leading to further tightening in Fed policy in H216. That said, we recognise that the near-term outlook for the currency remains fraught with uncertainty, especially if, as we believe, market risk-aversion rears its ugly head yet again.