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How Fed policy influences the dollar

It's no mystery that yield differentials between currencies can drive the relative behavior of currencies, but it's not always the case. For example, double-digit yields on a currency plagued by high inflation most likely can't keep that currency from falling relative to currencies with lower inflation and lower yields. But when you consider two major currencies, such as the Euro and the Dollar, with inflation rates that are substantially similar, then interest rate differentials can indeed explain much of the variation in the relative value of those currencies. That's what the two charts above illustrate.

The top chart shows 2-yr government yields in the U.S. and in Germany. These yields are best thought of as the market's estimate for what short-term rates are going to average over the next two years, and those rates in turn are largely determined by central bank policy. In the U.S., 2-yr Treasury yields are trading at 0.34%, which means the market expects the Fed to keep the overnight funds rate at 0.25% for most of the next two years. In Germany, however, 2-yr Bund yields are 1.0%, which implies that the market expects the ECB to keep its target rate at 1% for the next two years. Thus, US 2-yr notes promise a total return of 68 bps, whereas 2-yr bunds promise a 200 bps total return. The return on Euro-denominated bonds makes them more attractive than dollar-denominated bonds, thus attracting capital to the Euro and away from the dollar and causing the dollar to fall against the Euro. (The chart uses the Dollar Index, but that has a 0.98 correlation to the Euro over the past 5 years, so the story is the same.)

The bottom chart compares the yield differential between the US and Germany with the value of the dollar. Note that the two are highly correlated; today's widening yield differential in favor of Germany (lower rates in the US, higher rate in Germany) tracks the weakening of the dollar. This same dynamic is playing out between the US and Australia, where the central bank today raised its target rate to 4.75%. Since early last year, higher yields in Australia have helped propel the Aussie dollar to a 50% gain against the US dollar.

If the Fed "disappoints" the market tomorrow by announcing an unimpressive QE2 program, this would likely result in a strengthening of the dollar. That's because it would imply that the Fed wasn't quite as worried about the economy and deflation as everyone thinks, and that in turn would imply that the Fed would be less likely to keep rates at very low levels for as long as everyone currently thinks. And that, of course, would result in a rise in US 2-yr yields and a narrowing in the US-German interest rate differential, to the dollar's advantage.

I'm hopeful that tomorrow the Fed will err on the side of caution with its next round of quantitative easing. I don't see the need for QE2, and any additional easing at this point is only bad news for the dollar (much of which is already priced in). Weakening the dollar is not the way to strengthen the US economy, and printing more money is not the way to stimulate the economy. Forcing more dollars on the world only drives down the value of the dollar and reduces the demand for US investments.

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