Why the dollar is brushing off the decline in the 10 year yield

Although 10-year Treasury yields have backed away from the key 2.4% level, the dollar is ignoring developments at the longer end of the curve and concentrating on the shorter end of the curve, where 2-year yields are at their highest level since 2008.

The 2’s -10’s yield curve has also risen to its highest level since 2007 and it is now a mere 30 basis points away from being in positive territory and is 100 basis points higher than it was at the start of the year. While this spread has been increasing in recent years, the 2-year yield has really taken off since September, which corresponds with the low in the dollar index. After diverging for most of 2017, the 2-10-yr spread and the dollar index are back in synch, as you can see in the chart below. So, if you want to know where the dollar goes next, then it is a good idea to keep an eye on this yield spread.

With the 2-10-year spread at a historically significant high, the question is, can it move even higher. Below, we list the case for and against.

Reasons why Treasury yields may rise:

• The fundamental picture: this hasn’t changed. The US is growing at a decent pace and the labour market is creating jobs
• Inflation: this is a major driver of bond yields. Although wage growth remains stagnant, the Underlying Inflation Gauge, as measured by the New York Fed, has risen sharply to 2.83%, which is the highest level since 2007. This suggests that inflation is coming, which may mean that the Fed needs to hike rates at a faster pace than currently anticipated by the market, which could push yields even higher and boost the dollar further.
• Correlations: although there are multiple factors that drive a major currency like the dollar, the buck has a stronger correlation with the 2-year yield compared with the 10-year yield, which is why the dollar is ignoring the weakness in the 10-year yield and is instead seems to be following the 2-year yield higher.

Factors that could threaten the two-year yield:  

• Savings rate: This has slumped to its lowest level since 2008 at 3.1%, which may mean that the US consumer is dipping into their savings to sustain spending. Unless wages pick up consumption may slow, which could weigh on growth and cause the Fed to take a dovish path in 2018.
• The Fed: the new Fed chief, Jay Powell, is likely to follow the cautious path carved by Janet Yellen. Thus, rates are likely to rise at a slow and steady pace in the coming years. This is in contrast to other hawkish choices that Trump could have picked for Fed chief. Thus, the Powell premium may weigh on yields once he takes the reigns next year.

Overall, we believe that the case for higher short-term yields is strong right now, and we may see the 2-year yield continue to rise as we lead up to next month’s Fed meeting where the market is pricing in an 87.5% chance of a rate hike. At this meeting we will also get updated guidance on the path for interest rates in 2018. While this guidance could alter our view on the dollar, until then the path of least resistance for the buck looks higher, as it follows the trajectory of 2-year yields and the 2-10 year yield spread higher.

Chart 1:

Source: City Index and Bloomberg