We have been noticing that the 10-year US treasury has moved back above the magic 3 percent hurdle. Investors get 3 percent a year for holding the USD. At the same time the USD has come under pressure; from its low of 0.882 against the Eur on 14 August, it has retrenched by 3.5 percent now to 0.852 against the Euro. The 10-year Bund, Germany sovereign debt, pays a meagre 0.45%; any investors receives 0.45% a year for holding Euros for ten years.
Why does a substantial higher return on US government papers not warrant a strengthening USD?
As the FT writes, the divergence between US bond yields and the dollar is one of the more interesting developments we are seeing in markets. At some point higher bond yields, with the Federal Reserve set to raise overnight rates next week, should help the USD.
The chief currency strategist at Bank of New York Mellon notes… You´ve got a two-year German-US yield differential you haven´t seen in 20 years and still the dollar just cannot get a break.
The breakdown in the relationship where rising yields support the USD could signal that investor´s confidence in dollar assets has waned and that we see more outflows. Scotia Capital in Toronto notes that higher fiscal deficits and riskier monetary policy needs to be properly managed…
The key is that the market is being flooded with very short-term debt that investors are not keen to buy.
Mr S Englander, head of currency strategy at Barclays Capital in New York, has developed the following theory: investors need a discount to buy US debt; this discount can either be given by high rates or low exchange rates. Both do attract foreign investments. According to him the Treasury is flooding the market with short-term debt that no one is interested in buying.
His Bloomberg article noted earlier this year: the FED is capping the yield on the debt with its promises to raise rates gradually and to keep rates below long-term levels for some time. There is a surge of issuance at negative real rates.
The discount that foreign buyers require to induce them to buy comes through a weaker exchange rate. The Treasury is creating conditions where the rational market outcome is that the dollar must be weaker to create demand for all the low-yield debt that is being issued. As Mr Englander stresses: When yields are not able to move much because they are anchored by the FED, the discount required at the short-end relies wholly on a weaker exchange rate.
However, there is a limit to this: as the FT writes, …should we see 10-year real yields rise beyond 1 per cent (now 0.9%) and the nominal benchmark eclipse this year’s peak of 3.12 per cent, the dollar will probably find an ally….
So watch the market: a 10-year US rate above 3.12 seems to revert the USD fall.