The dollar, Treasuries and ‘US exceptionalism’

The relationships that tie the dollar and Treasuries are crumbling. — Reuters

ANY week with US inflation figures, Federal Reserve (Fed) and Bank of Japan (BoJ) policy meetings and a core eurozone nation plunging into political turmoil is bound to be sending a blizzard of conflicting signals for investors, and so it proved last week.

But one clear signal did emerge, a peculiarity strengthening the “US exceptionalism” narrative that’s drawing capital from all over the world into US assets – the breakdown of the traditional relationship between the dollar and US Treasuries.

Broadly speaking, the dollar and US yields often rise and fall in tandem, signalling a positive correlation between the two. Consequently, the correlation between the dollar and bond prices tends to be negative.

Last week, the 10-year yield tumbled more than 20 basis points for its biggest weekly fall this year. But this didn’t dim the dollar’s allure, as one might expect – the dollar had its best week since April.

It was a similar, although less stark, situation the week before too, indicating that the relationships that tie the dollar and Treasuries are crumbling.

A simple rolling 25-day correlation between the 10-year Treasury yield and dollar index has turned negative for the first time since last July. The correlation breakdown in the last week or so has been exceptionally rapid.

The correlation between the dollar index and the rolling 10-year Treasury bond future, which is usually negative, is now positive for the first time in almost a year. Again, much of that turnaround has been in the last week.

Falling Treasury yields are clearly no impediment to the dollar. Wherever they look, investors see reasons to hold US bonds and therefore unhedged exposure to the dollar – US disinflation, political risk in emerging (Mexico) and developed (France) markets, China’s economic malaise, and the BoJ’s reluctance to “normalise” policy.

It’s worth noting that the political and market turbulence in France will have an outsized impact on the dollar due to the euro’s near 60% weighting in the dollar index. All else equal, a 1% fall in the euro will lift the dollar’s broad value more than a 1% fall in the yen or sterling.

“Through all of this, the dollar remains king,” Brad Bechtel, global head of forex at Jefferies, wrote last week.

Lower US yields and eventual rate cuts from the Fed as inflation slows further should end up dragging the dollar back down again, Goldman Sachs’s currency analysts reckon, but not in the current environment of “disruption” overseas.

“For now, the dollar is supported as the ‘cleanest’ asset for global investors,” they wrote last Friday.

Go with the flow

The dollar index, a measure of its value against a group of developed market currencies like the euro, yen and sterling, is hovering at a six-week high and close to revisiting peaks last seen in October.

The obvious risk is one or more of these drivers sputters or goes into reverse. Perhaps the BoJ will raise rates next month and reduce its US$5 trillion balance sheet, or French politics cool and money flows back into eurozone assets.

It’s possible. It’s also possible that the bullish dollar narrative persists – Goldman and Evercore ISI are floating the 6,000-point mark for the S&P 500 this year, and Citi just downgraded European stocks to “neutral” and raised US to “overweight”.

“Potential dollar strength should be more conducive to US outperformance,” they note.

On the equity side, the case for buying Uncle Sam is well worn but, seemingly, nowhere near worn out. The tech and artificial intelligence boom practically puts big US tech in another universe, and the US economic and earnings growth mix also beats its rivals into the dust.

Bank of America flows data backs this up – US funds have attracted net inflows for eight weeks, dominated by demand for large caps and tech; Europe and Japan have registered outflows, albeit small ones, for four and five weeks, respectively.

Stephen Jen and his colleagues at Eurizon SLJ Asset Management take a longer term but no less bullish view. They reckon “US exceptionalism” can be measured by the outperformance of corporate America since the Great Financial Crisis, relative to European and Japanese peers as well as the US government.

Simply put, US companies are extremely profitable, in terms of profit margins and earnings growth, so it is no surprise that US equity prices an valuations are higher.

“Looking ahead, our best guess is that this divergence ... will more likely persist than converge,” Jen wrote last week, adding that disinflation will lower US bond and earnings yields, giving equity prices more room to continue rising.

“No, we do not believe US equities are too expensive.”

In that scenario, US bonds, stocks and the currency all appreciate. It’s a scenario we got a glimpse of last week. — Reuters

Jamie McGeever is a columnist for Reuters. The views expressed here are the writer’s own.

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