Future bond yield spreads point to dollar decline now

One question has dominated the currency market this year - why is the dollar falling when US yields are rising?

Numerous explanations have been put forward to explain the breakdown in this reliable correlation, but according to Nomura, the market has been asking the wrong question - or rather, it’s been looking at the wrong time-frame.

The key is to look further into the future than forex traders tend to do. By looking at the spread of 5-year rate differentials minus 2-year rate differentials, investors get an idea of what moves the market expects from central banks beyond the next couple of years.

And when this 2s5s rates spread is plotted against the dollar’s movement versus the euro, it shows a strong correlation since the start of 2016 - when Federal Reserve began to raise rates under former chair Janet Yellen.

There is also a notable correlation between the 2s5s rates spread and the dollar’s moves against the yen, and although the correlation did break down last year, it is showing signs of returning.

Why might this particular yields pattern be a better guide for the dollar’s path? “FX markets seem to have become very forward-looking, shrugging off near-term hikes and instead focusing on hikes further down the line,” says says Nomura’s Bilal Hafeez.

“Part of this may due to the use of QE and other points on the yield curve as policy tools by central banks. So the curve captures shifts in the expectations of changes in these tools as well as the usual rate hikes.”

And that forward-looking tendency is down to currency traders being hyper-sensitive to central banks exiting non-conventional monetary policy, Mr Hafeez adds.

If investors were to look beyond the next two years, says US economist Philip Suttle (who Nomura attributes), the US would have all but completed its tightening cycle and the European Central Bank tightening would be in full swing.

You could argue that this is an exercise in data-mining, Mr Hafeez admits. “Nevertheless, there do appear to be some yield arguments to support the case of continuing dollar weakness.”