Rising relative yield differential is good for the dollar

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FX Trading – Rising relative yield differential is good for the dollar
For last Friday’s forex entry, I penned Growth and inflation? Key to our 10 reasons the dollar has bottomed. I hope you believe me now. One of the key points to the dollar move was “Carry trade idea history.” History we think because the Fed may surprise on the interest rate front; we expect US interest rates on the front end of the curve to exceed anything Japan has to offer soon. In that case, the Japanese yen once again inherits the carry trade mantle. It is one reason why we are bearish on the yen going forward and why our Members are positioned for such a move.

But we also expect relative US growth will exceed its competitors in Europe (and Japan). Relative growth is always a vital prop for any currency and it should be no different when it comes to the dollar in this cycle.

Our case for growth and inflation is a relative calculation. However, the argument, “The Case for Higher Real Yields,” from Richard Berner & David Greenlaw, two excellent economists from Morgan Stanley, provides more than enough meat for our relative US growth and rising rate expectation story. A few excerpts below [our emphasis]:

“We think 10-year Treasury yields will jump to 5.5% by the end of 2010, driven primarily by a rise in real rates to 3% or more. That call is clearly inconsistent with the consensus view of modest growth and declining inflation, and it is light years away from the current level of real TIPS yields at 1.3%. Even those who agree with our somewhat upbeat view of sustainable growth and moderate inflation think that our rate call just does not jibe.

“…Ex ante, investment is poised to increase more than saving; higher rates required to clear market. At first blush, the increased saving that we expect may sound bullish for interest rates. What many fail to appreciate, however, is the extent to which investment outlays will rise over the course of the next year in spite of the rise in rates. Housing, of course, is credit-sensitive, but credit availability and collateral requirements are as important as interest rates. The fact that traditionally measured housing affordability has skyrocketed and yet housing is staging only a modest recovery from a record plunge speaks to the importance of credit availability. Our hunch is that improved availability in the coming year means that housing demand will improve even as rates rise.

“For Corporate America, there is a parallel story. Capital spending plunged in the recession to an unprecedented degree, and new investment is needed to rebuild capital stocks. The ‘accelerator’ of rising output on a sustained basis and improved corporate cash flow will also drive capex higher. Moreover, empirical work suggests that corporate capital spending is relatively insensitive to changes in interest rates. Finally, we believe that companies will shift from a record 10 quarters of liquidation to accumulating inventories by year-end. Combined, this shift to sustainable growth in housing, business investment and inventories will result in a significant increase in private credit demand.

“The upshot is that the necessary balance between rising saving and rising net investment is unlikely to occur at today’s interest rates. Finally, two other factors are expected to lift real interest rates. First is a repricing of the likely path for short-term interest rates. Currently, fed funds and eurodollar futures are pricing in a 90bp move up in rates by year-end 2010, and a cumulative move by year-end 2011 of about 200bp – less than what we expect through year-end 2010. As a result, we think the market has more repricing of the yield curve to do. Second, uncertainty over fiscal credibility and inflation will lift term premiums and likely add to the looming pressure on real yields.”

If we compare the yield curve of the US to the Eurozone, you can see that yield advantage in Europe is only on the front end of the curve. Already US yields for beyond 5-yr benchmarks are ahead of the Eurozone.

US (black) vs. Eurozone (red) Yield Curve (spread difference green at bottom):

Our bet is the problems in the Greece and increasing expectations of a deceleration in German growth means the US sooner than later shows a yield advantage across all terms of the yield curve. And if Mr. Berner and Greenlaw are correct about a 5.5% 10-year yield by the end of 2010, the yield advantage favoring the US could be big!

10-yr US Benchmark Yield (black) and US$ index (purple) Weekly: The last time we saw a 5.5% yield was back in May 2001; incidentally the US $ index (purple line left axis) was near 120).

Have a great weekend.