Any week with US inflation data, Federal Reserve and Bank of Japan policy meetings and a key Eurozone country sinking into political turmoil is bound to send a blizzard of mixed signals to investors, and so is demonstrated last week.
But a clear signal has emerged, a peculiarity that reinforces the narrative of “US exceptionalism” that is attracting capital from around the world to American assets: the breakdown of the traditional relationship between the dollar and US Treasuries.
Generally, the dollar and US yields often rise and fall in tandem, signaling a positive correlation between the two. As a result, the correlation between the dollar and bond prices tends to be negative.
Last week, the 10-year yield fell more than 20 basis points, marking its biggest weekly decline this year. But this hasn’t dulled the dollar’s allure, as you might expect – the dollar had its best week since April.
A similar, albeit less clear-cut, situation also occurred the previous week, indicating that the relationship between the dollar and Treasuries is crumbling.
The simple 25-day correlation between the 10-year Treasury yield and the dollar index turned negative for the first time since last July. The breakdown of correlation over the last week or so has been exceptionally rapid.
The correlation between the dollar index and the 10-year Treasury future, which is usually negative, is now positive for the first time in nearly a year. Again, much of the turnaround occurred in the last week.
Falling Treasury yields are clearly not a headwind for the dollar. Everywhere 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 BOJ reluctance to ‘normalize’ politics.
It is worth noting that political and market turmoil in France will have a greater impact on the dollar due to the weighting of the euro in the dollar index, which is almost 60%. All things being equal, a 1% decline in the euro will lift the overall value of the dollar more than a 1% decline in the yen or pound.
“Through it all, the dollar remains king,” Brad Bechtel, global head of FX at Jefferies, wrote last week.
Lower US yields and possible Fed rate cuts as inflation slows further should end up dragging the dollar lower again, according to currency analysts at Goldman Sachs, but not in the current context of “disturbances” abroad.
“For now, the dollar is supported as the ‘cleanest’ asset for global investors,” they wrote on Friday.
FOLLOW THE FLOW
The dollar index, a measure of its value against a group of developed market currencies such as the euro, yen and pound, is hovering at six-week highs and is close to revisiting peaks last seen in October.
The obvious risk is that one or more of these drivers collapses or reverses. Perhaps the BOJ will raise rates next month and reduce its balance sheet by $5 trillion, or French politics will cool down and money will flow back into eurozone assets.
It’s possible. It’s also possible that the bullish dollar narrative persists – Goldman and Evercore ISI are eyeing the 6000 point mark for the S&P 500 this year, and Citi just downgraded European stocks to ‘neutral’ and raised US stocks to ‘overweight’.
“Potential dollar strength should be more conducive to U.S. outperformance,” they note.
As for stocks, the case to buy Uncle Sam is well known but apparently not yet exhausted. The boom in technology and artificial intelligence practically puts US big tech in another universe, and the US’s mix of economic and earnings growth beats its rivals in the dust.
Flow data from Bank of America confirms this: US funds have attracted net inflows for eight weeks, dominated by large cap and tech demand; Europe and Japan recorded outflows, albeit small, for four and five weeks respectively.
Stephen Jen and his colleagues at Eurizon SLJ Asset Management have a longer-term, but no less bullish view. They believe that “US exceptionalism” can be measured by the outperformance of American companies after the Great Financial Crisis, compared to their European and Japanese peers and the US government.
Simply put, US companies are extremely profitable, in terms of profit margins and earnings growth, so it’s no surprise that US stock prices and valuations are higher.
“Looking ahead, our best guess is that this divergence… is more likely to persist than converge,” Jen wrote last week, adding that disinflation will lower U.S. bond and earnings yields, giving stock prices more room to continue climbing.
“We don’t believe U.S. stocks are overpriced.”
In this scenario, US bonds, stocks and currency all appreciate. It’s a scenario we glimpsed last week.
(The opinions expressed here are those of the author, a Reuters columnist.)
