Is the US Yield Curve Driving the Outlook on the Dollar, Euro and Pound Index?

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There are basically two types of investment in the world. One is the riskiest investment – “stocks” and the other is the most risk-free. Or we can say an asset class that provides fixed income in the form of coupons. This includes short-term “notes” or long-term “bonds”. In the case of a growing inflationary environment where the central bank has yet to tighten, stock markets generally perform better as money seeks a higher return.

However, rising inflation can have a negative impact on fixed income assets, which could lead to higher interest rates. As interest payments on existing fixed income assets become less competitive with higher rated fixed income instruments, the prices of existing fixed income assets will generally fall.

Let’s check the current scenario. The recent crisis-free Fed slowdown and October payroll data are behind us. The policy of the Bank of England and the European Central Bank is over – the BoE has acted against all odds and the ECB has remained silent. Now, what is the outlook for the major country’s bond yield and how will this shape the future of that country’s currency? Let’s check it one by one.

US Bond Yield Outlook:

At a recent meeting, the Federal Reserve announced plans to end its pandemic bond purchase program by June 2022 or, as expected, $ 15 billion per month from November. 2021. While also decreasing, Fed Governor Jerome Powell again added the word “transitional.” The yield on two-year Treasuries, which tends to rise and fall with expectations of rate hikes, recently exceeded 0.5% to reach their highest level since March 2020.

The 10-year yield also increased to 1.60% immediately after the policy. However, 2-year and 10-year yields fell on Thursday after the BoE’s dovish policy. And after releasing a stronger-than-expected US jobs report, the yield curve flattened as the market anticipated a faster rate hike than the Fed projected.

The annual rate of inflation, for example, jumped to 4.4% in the 12 months of September and peaked in 30 years, using the Fed’s preferred PCE price indicator. And the increase in the Consumer Price Index (CPI) reached 6.2% (year-on-year) – the highest since 1990.

The scenario for the next few months could resemble that of the Fed’s policy meeting in June – where they first accepted sustainable inflation and hinted at a decrease. However, from mid-July to the end of September, the tone had been mixed to conciliatory, and the curve accentuated. But in October, all of a sudden, the members of the Fed adopted a hawkish tone. Generally speaking, after the Fed cut in November as well, the Fed could calm the nerves of the market by settling the expectation of a rate hike to par and will not allow the market to anticipate further hikes. short term.

Although the flattening of yields still points to a double rate hike in 2022. The Fed generally telegraphs its policy stance very well, but lags behind. Therefore, the return over the entire mandate is likely to increase over the next few months due to higher expectations that the US will outperform its peers like the EU and the UK.

In addition, the flattening of the yield curve could continue in the short to medium term. The 10-2 year yield spread chart suggests a further flattening towards 70-80bp from the current 105bp. It’s not that the 10-year yield won’t increase. It is also more likely to cross the 1.75% mark and exceed 2% in the medium term. But compared to that, we might see a bigger jump in 2- and 5-year yields.

The hawkish tone flattens the yield curve (the difference between short and long term yields decreases) and the dovish tone steepens the yield curve (the difference between short and long term yields increases).

Therefore, there is a strong case for the DXY to rise to 97.00 – 98.50 over the next 2-3 months and to the 100 level over the next 5-6 months.

UK and German Bund yield outlook:

UK and German yields are primarily affected by the outlook for US yields and then by global inflation. In recent months, inflation figures around the world, especially in developed markets, have exceeded central bank target levels.

This turns out to be a headwind for bond prices. And therefore, the yield through MDs increases. Despite higher yields that take into account future rate hikes, central banks like the BoE and the ECB face a deep dilemma over their monetary policy. In a gloomy economy, they cannot relax their grip on easing. Recently, the BoE fell short of market expectations for a 15 basis point hike. After the ruling, the UK 5-year yield posted the biggest drop since the Brexit vote and a 1-year rate almost halved, marking their biggest daily move since the financial crisis of 2009. From the zone euro, the ECB clearly declares that it is still a long way from a rate hike. But the market just wanted to discount everything today itself and in advance. The yield on the German Bund collapses after ECB policy, dropping from -6 bps to -30 bps. Given the gloomy economic outlook amid rising fourth wave cases, the ECB is not expected to withdraw the PEPP anytime soon.

Overall, UK and German 10-year yields are likely to remain on a mixed to bearish note as higher inflation could help them rise, but gloomy growth prospects in the UK and Europe may calm them down. As a result, the yield spread between US-UK and US-German yields is expected to widen in favor of the US. This will surely support a stronger US Dollar index and at the same time set new bearish levels for the Euro and the Pound.

Outlook:

Now the policies of the ECB, the Fed and the BoE are behind us. The verdict is very clear. The Fed announced a cut as planned, however, it calmed the market for a rate hike. Expectations are even higher for two rate hikes in 2022, and so the yield curve is actualizing as it flattens. In this case, the DXY could rise to 97-98.50 in the short term and 100 in the medium term. The BoE’s policy was akin to “advanced delusion” because it acted against market expectations and its position is not very clear. And as a result, the pound could drop to the 1.32 level over the next 2-3 months. The ECB guides a little better than the BoE, but is unsure if it will be able to end the PEPP by March-2022 and even if it does, what about other purchasing programs? ‘assets. Certainly, the rate hike is not possible until the end of 2024. Thus, the euro will remain under pressure due to the underperformance and a stronger dollar. We can expect the EURUSD to decline towards 1.12 over the next 2-3 months.

—Amit Pabari is the Managing Director of CR Forex Advisors. The opinions expressed are personal.

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