Soaring Bond Yields and the Dollar

"Creditors have better memories than debtors."

- Benjamin Franklin

Bond markets around the world have had a rough month, as talk of a global recovery and concerns about monetary and fiscal stimulus have sent yields soaring. This is especially true at home, where 10-year yields are up over 100 basis points since quantitative easing (QE) was announced on March 18.

In "normal" times, higher yields led to currency strength and we had seen that pattern play out until last month. Higher yields traditionally increase a currency's relative attractiveness and often reflect optimism about economic growth. In addition, yields were going up because risk aversion was declining, leading to money flowing out of bonds and into riskier asset classes, including equities.

As the chart indicates, interest rates and the dollar fell sharply on March 18 after the Fed announced the beginning of QE. For the next month, rates edged higher and the dollar rose as well. The dollar index hit a near-term high on April 21; however, since then the dollar has fallen while rates have continued to climb. So what changed?

There are many reasons for the spike in rates and I mentioned some of them earlier: reduced risk aversion (which leads to money flowing out of treasuries), hopes of an economic recovery, an increase in inflationary expectations, increased issuance to fund Treasury's expanded borrowing needs leading to excess supply and reduced foreign demand. I believe most of them have been valid to an extent at various points in time.

However, in early March the focus was on the positive reasons for higher yields, such as reduced risk aversion and hopes for a recovery, which is why the dollar was strengthening as rates rose. Now the focus is largely on the negative: concerns about fiscal policy, excessive supply, inflation and waning foreign demand. There is also the growing recognition that higher yields could choke off the recovery by hurting the housing market even further through higher mortgage rates. There are already signs this is happening and mortgage delinquencies are soaring. Partly because of the dollar's weakness and partly for other reasons, oil prices are going up, posing another challenge for consumers. These concerns are combining to undermine the dollar.

I believe the concerns and the market's response are valid - our economy remains fragile and higher rates could derail the recovery. Out of the G10 currencies, the USD probably has the weakest fundamentals, in my opinion, followed by the GBP, EUR and JPY, with the AUD and CAD leading the pack. Asian currencies, including the CNY, TWD, INR, MYR and others, have the brightest prospects. For the stronger economies, higher rates are a vote of confidence and act as a brake on economic growth, which is often welcomed. For a struggling economy that is dependent on foreign capital to finance its fiscal and external deficits, rising rates choke off a recovery and scare away foreign investors - hardly a comforting thought for us.

I don't intend to single out our economy and the dollar when it comes to challenges; other countries face similar circumstances. Europe, Britain and Japan are in the same boat, though there are some moderately optimistic signs for Japan recently. It is likely that we will see significant additional QE from the Fed to keep rates from spiking further and the ECB and BOE will probably do the same. There is a key difference, though - our markets are larger, which means the Fed is likely to have to really ramp up the size of additional QE to make an impact. For Britain and Europe, smaller amounts can be far more effective. In addition, the markets expect both Europe and Britain to begin to raise rates next year (unlikely in my opinion as far as Europe is concerned), while the expectation is that the Fed will probably start raising rates in late 2010 or 2011 (I believe 2011). Those rate expectations are providing relative support for those currencies at present and are hurting the dollar.

The dollar is also currently suffering more than the EUR and GBP because it is still the world's primary reserve currency, and therefore, subject to greater scrutiny. There are rumblings from the BRIC nations about reducing their exposure to the dollar and we have heard similar comments from OPEC and some of the surplus Asian countries in the past. China is likely to be a key player in determining the direction of the dollar and interest rates. They have huge investments in our markets and are concerned about the impact of QE and the fate of the dollar. My belief is that they will start to slowly liquidate a portion of their dollar bond holdings and move some, if not all, those funds to other markets and asset classes. This process may be under way already.

In conclusion, higher bond yields are not helping the dollar currently. They may actually be hurting and I don't see that dynamic changing. I do believe yields in the U.S. and elsewhere will moderate in the near term (but rise again next year) once investors come to terms with QE and realize that the current demand gap virtually guarantees no inflation for the foreseeable future. However, concerns about deficits and fiscal stimulus will probably keep yields higher than fundamentals would otherwise dictate, here and around the world. That hurts the weaker economies in particular and the U.S. leads that group.

The dollar ought to remain under pressure as a result, until signs of real, sustainable economic growth emerge. I expect growth to pick up later this year in Asia, weak to moderate growth for the other G10 countries until 2010 and U.S. growth to remain non-existent to anemic until 2011. The dollar's weakness is welcome in this context, as it is effectively a form of easing and helps offset some of the tightening caused by higher yields. As a rule of thumb, a 100-basis-point increase in long-term rates has historically equated to 200 basis points of tightening in Fed Funds, clearly not what the Fed wants or the economy needs at this juncture. The likely policy response will be a juggling act: talk up a future economic recovery while trying to ratchet down inflation expectations, use QE to hold rates in check and let the dollar slide. Going back to Mr. Franklin's comment above, though, we are a debtor nation and our creditors might be less than enthusiastic about the cocktail being concocted.