Bond yields are driven by two factors: the prospect of higher future growth or the expectation of higher inflation, or a combination of the two. Both these factors are important in gauging future decisions made by central banks, who are more likely to tighten monetary policy (increase interest rates) if either of these two factors are high enough to support such a decision. Despite this logic, there is no real positive correlation (one in which higher bond yields correspond to a stronger dollar) between the direction of bond yields and the value of the dollar. In fact, historically, the dollar has tended to appreciate when bond yields collapsed. More important has been the path of relative interest rates. For example, the ebb and flow of EUR/USD currency pair has tracked the yield differential between Bund and Treasury yields since the 1970s. See Figure 1.
Currencies react more to the path of relative real interest rates (interest rates which have been adjusted to remove the effects of inflation) than to nominal interest rates. Rising inflation is normally negative for the value of a currency since its purchasing power is eroded. In a globally competitive system, the currency will adjust downward to equalise prices across borders. However, rising growth expectations allow monetary policy rates (interest rates set by the central bank) to be increased and to catch up with a higher neutral rate (the real interest rate expected to prevail when the economy is at full strength). This improves the relative rate of return for bond investors and encourages capital inflows in search of these returns. As has been demonstrated in the past, there has been a longstanding relationship between real interest rate differentials and the path of the currency.
Despite bond yield increases on a global basis, U.S. real interest rates have not risen much. They have in fact decreased when compared to countries like Australia, the UK, and New Zealand, which is negative for the dollar. Figure 2 shows that the dollar tends to respond to the level of real interest rates in the US, compared to the rest of the world. When US real interest rate differentials are positive, the dollar tends to appreciate on a year-over-year basis.
Figure 3 shows that at present the U.S is below the median when comparing real yields against its G10 counterparts and needs to increase by 50-to-100 bps before differentials become positive.
Foreign inflows into US bonds remain negative. This suggests that despite the rise in U.S. yields since March last year, foreign investors are still not convinced they are sufficiently high to compensate for the rising US twin deficits (both a fiscal and current account deficit). Relative interest rates however are just one factor which drives the exchange rate. Inflows into the U.S. equity market have been strong. This suggests that equity flows are becoming an ever increasingly important driver in currency valuations. See Figure 4.
More than ever investors need to look to other drivers for direction. The flow of capital is more dependent on perceptions of where to find higher relative rates of return which in turn are based on relative growth fundamentals. The U.S. equity market has become very tech heavy. The tech and health care sectors are sensitive to interest rate movements. Bond yields affect the value of these stocks and are thus important in determining the performance of these sectors. When bond rates increase, stock prices generally decrease. Therefore, rising bond rates have the effect of negatively impacting the U.S. equity market, thereby reducing flows to the U.S. and in turn leading to a weaker dollar.
The U.S has yet to approve the next round of fiscal stimulus. President Biden has proposed a $1.9 trillion package, which on the heels of the $900 billion stimulus package passed in December of 2020, should inject another 13% of GDP into the economy. This should provide a welcome boost to not only U.S. growth, but to global growth as well. Such a large amount of stimulus will have implications for the rest of the world too. Pent up demand will gradually translate into actual sales. Investor sentiment already reflects the optimism in the market for higher global growth. Emerging market currencies like the rand have benefited from this change in risk appetite as is evidenced in the recent bout of rand strength over the past few months.