The fate of the dollar will depend on the yield curve

The inversion of the yield curve is one of the most discussed topics on Forex. FOMC doves focus on the increased risks of the difference in long-and short-term debt rates sliding into the negative area, which over the past 50 years has allowed to predict all 7 downturns of the US economy. Hawks argue that the markets in recent years have changed significantly: the quantitative easing programs have made the demand for 10-year Treasury bonds insatiable, and the tax reform warms it further. However, former Fed Chairman Ben Bernanke, commenting on the dynamics of the yield curve before the 2008 crisis, also spoke about the volatility of financial markets ...

Dynamics of the yield curve in the US

Source: Reuters.

The fate of the US dollar will depend on whose viewpoint is dominant within the FOMC. If the hawks take the upper hand, the central bank will continue to normalize monetary policy, and the USD index will have good chances for further growth. On the contrary, the victory of the doves will force the Fed to pause the process of raising the federal funds rate, which will lead to the closing of long speculative positions in the greenback. In this regard, investors should have a clear understanding of where the yield curve moves, and how the Fed looks at it.

Let's discuss this in plain language. If you come to the bank in order to deposit your money, you see that the rates for long-term deposits are usually higher than for short-term deposits. The difference is a kind of risk premium, since you can withdraw money from the deposit in 3 months or 2 years without loss of interest faster than with a deposit with a term of 10 years. However, the rate is the price of money. And if the demand for long-term deposits is high, then it  does not make sense for the bank to raise it too high. On the other hand, tightening monetary policy in the country makes it necessary to increase the profitability of short-term deposits, as they are usually tied to the central bank's key rate. It is this process that we are currently observing in the US bond market. The high demand for 10-year Treasuries keeps their profitability stable, while the monetary restriction of the Federal Reserve raises rates on 3-month and 2-year debt obligations.

Dynamics of the yield of US Treasury bonds

Source: Reuters.

The stability of long-term debt yields speaks of the uncertainty investors feel in terms of the prospects of the US economy: few people believe that the fiscal stimulus by Donald Trump will have a lasting effect. Demand for these securities is supported by a strong interest in safe haven assets during the trade wars and large-scale flows of cheap liquidity from the implementing of QE by central banks. At the same time, the need to finance tax reform leads to an increase in the planned volumes of short-term liabilities. Investors drop them in the secondary market in order to get higher bids than current ones at auctions.

Thus, the reasons for the potential inversion of the yield curve are known. The question is in the timing and reaction of the Fed. Many Bloomberg experts believe that the indicator will go to the red zone as early as 2019, and in 2020 the US economy will face a recession. It's not the best option for Donald Trump, who is to be re-elected just then. In this regard, it becomes clear why the leader of the White House is putting pressure on the Federal Reserve criticizing it for raising the federal funds rate. 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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The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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