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.
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.
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.
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?
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