Tuesday, May 10, 2011

Fed expectations are what is hurting the dollar

2-yr sovereign yields can be thought of as the market's best guess for the average short-term monetary policy rate over the next two years. Today's 0.6% yield on 2-yr Treasuries therefore means that the market is expecting the Fed funds rate to average 0.6% over the next two years: rising from today's 0.1% to 1.5% two years from now, with the first tightening not coming until until March of next year. 2-yr German yields, in contrast, stand at 1.7% today, which implies that the European Central Bank's target rate is expected to rise from today's 1.25% to a little over 2% two years from now.

The blue line in this next chart represents the difference between the yield on 2-yr Treasuries and 2-yr German bonds. The spread is currently negative, meaning that U.S. yields are trading substantially lower than German yields, and that in turn means that the market is expecting the ECB to be materially tighter than the Fed over the next two years. The fact that the red line (the value of the dollar against other major currencies) is fairly tightly correlated (0.81) to this spread strongly suggests that the Fed's accommodative monetary policy stance is largely responsible for the dollar's weakness; the Fed is expected to be much easier than other central banks, and that reduces the world's desire to own dollars (who wants to own a currency that is going to be in oversupply for the next two years?). By this logic, if the Fed were to tighten sooner and by more than the market currently expects, that would most likely result in a stronger dollar. Similarly, a decision by the Fed to postpone tightening would likely weaken the dollar.


Benjamin Cole said...

If the global economy expands in the next 20 years like it did 1988- 2008, and the US dollar stays in a range that enhances trade and exports, hold onto your hats.

We might see an export boom and domestic prosperity the likes we have never seen before. In fact, I think that is a very possible outcome.

William said...

"If ____ in the next 20 years then _____"

Just fill in the blanks ;~)

What is the average holding period for a stock in a stock mutual fund these days? Most "investors" can't "see" beyond the next 6 months.

I don't find such speculation at all useful.

TradingStrategyLetter - Weekly Summary said...

LOL. Good point. If my aunt had a beard she'd be my uncle.
A good reason why the global economy expanded in the 'past' 20 years was based on flawed, distorted, and corrupt fiscal, monetary, and Fed policy (sic).
We would be left with $28+ trillion in 'unpayable' debt, mind numbing future legacy obligations, and a 'totally' worthless currency.

Benjamin Cole said...

Well...maybe such speculation is not useful, given the audience. But more importantly, recent history suggests my speculation will be accurate.

TradingStrategyLetter - Weekly Summary said...

Zero political will exists to allow free markets to find normal and healthy levels.