Primary Dollar Down-Trend Intact While Real Yield Curve Flattens

Authored by Simon White, Bloomberg macro strategist,

The prevailing downwards trend in the dollar is primed to remain intact while the real yield curve flattens.

FX is one of the hardest markets to get consistently right. Traders often employ a lot of leverage so there is little room for error, or for indiscipline with stops or sizing. But sometimes getting the bigger trends is not as frustratingly hard.

One of the best leading indicators for the dollar, for instance, is the real yield curve. The intuition is the dollar is driven at the margin by the real return of foreign investors into US yields.

The real yield curve peaked last summer, a month or two ahead of the DXY’s peak in September. The curve has then been flattening aggressively as front-end real yields rise, first due to Fed interest-rate hikes, and now due to CPI falling.

As the chart below shows, there is no change in the real yield curve’s decisively negative trend, strongly suggesting the primary trend for the dollar remains down.

Some of the recent dollar weakness has been idiosyncratic, i.e. driven by fundamental reasons driving other currencies higher. The yen’s strength, for instance, is the main reason for USDJPY’s recent fall. Expectations the BOJ might tighten policy as its meeting later this month likely prompted some short covering.

However, most of the dollar’s weakness looks due to pure-dollar effects. The euro this month, on the other hand, looks to have been swept almost entirely along by dollar weakness.

This is the same on longer time scales too - most of the euro’s strength since last year is more of a dollar-weakness phenomenon.

The euro is thus more vulnerable to a weakening of the US currency. However, we are not likely to see a major reversal of its trend while US inflation is falling, keeping pressure on the real yield curve.