The future fate of the dollar will depend on the yield curve

Inversion of the yield curve is one of the most discussed topics on FOREX. FOMC “doves” focus on the increased risks of slipping the difference in long- and short-term debt rates into the negative area, which over the past 50 years has made it possible to predict all 7 recessions in the US economy. Hawks argue that markets have changed significantly in recent years: quantitative easing programs have made a demand for 10-year treasury bonds insatiable, and tax reform is fueling it even further. However, ex-Fed Chairman Ben Bernanke, commenting on the dynamics of the yield curve on the eve of the 2008 crisis, also spoke about the volatility of financial markets…

The fate of the US dollar will depend on whose point of view is dominant within the FOMC. If hawks prevail, the central bank will continue to normalize monetary policy, and the USD index will have good chances for further growth. On the contrary, Victoria’s “pigeons” will force the Fed to pause the process of raising interest rates on federal funds, which will lead to the closure of long speculative positions on the greenback. In this regard, investors should have a clear understanding of where the yield curve is moving, and how the Fed looks at it. 

Let’s try to talk on this topic in simple language. If you come to the bank in order to place your money, you see that the rates on long-term deposits are usually higher than on short-term ones. The difference is a kind of risk premium since you can withdraw money from a deposit for 3 months or 2 years without loss of interest faster than for a deposit with a term of 10 years. However, the rate is this price of money. And if the demand for long-term deposits is high, then the bank does not make sense to raise it too high. Monetary tightening, on the other hand in the country, makes it necessary to increase the profitability of short-term deposits, because they are usually tied to the key rate of the central bank. It is this process that we are witnessing now in the US bond market. High demand for 10-year Treasuries keeps their yield stable, while monetary restriction by the Fed raises interest rates for 3-month and 2-year debt.

The stability of long-term debt returns indicates investors’ uncertainty about the prospects for the US economy: few people think that the fiscal stimulus from Donald Trump will have a lasting effect. Demand for these securities is supported due to the high interest in safe-haven assets during the period of trade wars and large-scale flows of cheap liquidity from central banks implementing QE. At the same time, the need to finance tax reform leads to an increase in the planned volume of issues of short-term obligations. Investors dump them in the secondary market in order to get higher than now auction rates. 

Thus, the reasons for the potential inversion of the yield curve are known. The question is the timing and reaction of the Fed. Many Bloomberg experts believe that the indicator will go into the red zone already in 2019, and in 2020 the US economy will face a recession. Not the best option for Donald Trump, who will be at that time re-election. In this regard, it becomes clear why the owner of the White House puts pressure on the Federal Reserve, criticizing him for raising the rate on federal funds. Will the central bank succumb to criticism of the president? The road that the US dollar will choose will depend on the answer to this question.

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