Does a flattening yield curve signal pain for the dollar?


The latest news from the FOMC indicates a March hike of the Fed’s policy rate would “likely be appropriate” so long as “…employment and inflation are continuing to evolve in line with [their] expectations”. This news has increased the market implied probability of such a hike a further 5% to 94%, continuing the ramp up from just under 40% a little over a week ago.

 

111

 

As expectations for short term interest rates continue to rise, we are beginning to once again observe a flattening of the US yield curve (short term rates rising disproportionately more than long term rates). This flattening can be illustrated by overlaying the current yield curve with curves from 1, 2, and 3 years ago, as shown below.

 

222

 

Stepping back to look at the bigger picture, many ask what does a flattening yield curve mean for investors, and more specifically, might such a flattening mark the end of the dollar bull-market we’ve been observing since late 2011?

 

For starters, using the slope of the yield curve as a leading indicator for predicting economic recessions is not a new phenomenon (see here for a short list of literature on the topic). Generally speaking, a flattening of the yield curve can be interpreted as a warning sign that overall economic activity is starting to slow, and that expectations of future inflation are beginning to dwindle. A negatively sloping yield curve takes this warning one step further.

 

333

 

We see above that an inverted yield curve (defined as a negative spread between long term and short term interest rates) has been a precursor to all three economic recessions observed in the US since 1986 (which are indicated by the shaded areas on the chart). But what does this mean for the dollar?

 

555

 

In terms of broad dollar performance against a basket of the other major currencies, Treasury spreads appear to show little to no historical correlation in the data, suggesting they serve as a poor predictor of whether dollar strength will continue as the curve flattens (shown above).  This is unsurprising, for a couple of reasons.  Firstly, the factors which drive currency markets are relative rather than absolute; it also matters what the yield curves are doing in other countries and currency areas.  Secondly, as the world’s reserve currency, the US dollar can often act in very idiosyncratic ways – for example, it strengthened during the 2008 financial crisis as investors viewed the currency as a haven in a time of global financial upheaval.

 

However, due to the particular circumstances of the current USD bull market, the current flattening of the US curve may prove to be a warning signal worth keeping an eye on.  As the USD is already in  overvalued territory, and because the dollar’s strength is being driven primarily by an expectation of continuing monetary policy divergence, then the current USD appreciation could be limited by a flattening yield curve, if this places limitations on how quickly the Fed can continue to hike.  It is worth highlighting the fact that the euro yield curve has steepened compared to a year ago.  Could it be that monetary policy divergence is reaching its limits?

 

Author: Josh Macdonald

 



 

White Papers


 

FX Hedging:

10 Common Pitfalls

Download> 

Commodity & FX Risk:

An Integrated Approach

Download> 

The Corporate Use of Credit Derivatives:

Where Next?

Download> 

Corporate Hedger’s Guide to Basel III

Download>

Currency Volatility – Are markets nearing an inflection point?

Download>

Testimonial

FX Risk

 

“Validus designed an innovative and practical hedging strategy to address our underlying FX risk in the context of very distinct and diverse sources of competition. We are delighted with the outcome and impressed with their on-going response to the changing business and market dynamics”.

 

Paul Stobbs, Managing Director, Attraction World

Testimonial

Private Equity

 

 “The Validus team understand how private equity thinks about financial risk management issues and they are rigorous in the way they help our portfolio companies to understand and mitigate their risks.”

 

James Markham, Partner – Portfolio Management, Graphite Capital LLP

Testimonial

FX and Commodity Risk

 

“Validus provides us with independent strategic advice relating to our long-term currency and commodity risk management program.  The people are extremely capable and collaborate very well with our finance and operations teams here at JD Irving.”

 

Mark Bettle, Director, J.D. Irving Ltd.

Testimonial

FX  Risk

 

 “Validus developed a tailored hedging solution to mitigate the risks from our unique combination of existing supplier agreements. The implementation and management of this rolling hedging programme with our FX service providers has been expertly and efficiently handled”.  

 

Mark Goldby, Finance Director, SMS Electronics Ltd.

Testimonial

Commodity Risk

 

“Validus worked with us to develop a comprehensive commodity risk management programme – their analysis was both insightful and actionable.   We particularly value their independence, and they continue to work alongside our internal team to ensure our commodity price risks are managed effectively”


Gerry Gray, Finance Director, Strix Ltd.


Testimonial

FX, Commodity & Interest Rate Risk

 

“Validus comes up with risk management solutions that are innovative and comprehensive but practical to implement, that is their strength compared to other consulting companies we have worked with in the past.  Validus provided valuable insights into how FX, interest rate and commodity risks impact our organisation, and provide actionable recommendations and solutions.”

 

Andrew Ayres, Finance Director, U-POL Ltd.

Recent Comments