Bank of New York Mellon : Why does the U.S. Dollar continue to underperform?

Written by: Simon Derrick | Chief Markets Strategist, BNY Mellon

One clue as to why the US Dollar (USD) index continues to underperform comes from noting that its latest leg lower first emerged on December 13 and coincided with the start of a sharp rise in yields across the curve (the 2 year/10 year, 5 year/30 year and 2 year/20 year yield gaps are virtually unchanged since then).

It also coincided with both the Federal Open Market Committee's (FOMC) most recent rate hike and the news that Senate Republicans had secured enough votes to pass the tax reform legislation.

While it is true that the market remains split about the pace of US rate hikes in 2018, it's hard to argue that the USD's poor performance has had anything to do with investor scepticism about the Fed given that 2018 dated Fed funds futures have been declining steadily since early November.

It's also hard to argue that the December FOMC statement had a material impact on sentiment given that the pace of declines in Fed funds futures post the meeting has been almost exactly the same as that seen in the month and a half prior to it.

This suggests that the key news story for the USD was not the FOMC's expected move but, rather, the tax deal. More specifically, given the accompanying sharp rise in yields seen since the 14th (the 2-year is up 34 bps since then), it indicates that the key factor driving USD weakness has likely been concerns that the tax bill will not pay for itself via higher growth.

A report by the Joint Committee on Taxation published at the start of December argued that the bill would leave the government facing a revenue loss of about USD 1 trillion over 10 years.
This makes an interesting comparison with the situation in the mid-1980s, the last time that concerns about the twin deficits had a material impact on the USD.

Those concerns first began to make themselves felt in late February 1985 - a full seven months before the Plaza Accord - and saw the USD index fall 47% over the next 34 months, helping spur a doubling in the price of the Dow Jones Industrial Average (DJIA) over the next two and a half years.

Although bond yields fell in 1985 and through into the summer of 1986 as the Fed cut rates, they rose sharply following the Louvre Accord as policy began to be tightened (the 10-year yield rose 160 bps over the course of 1987 ending at 8.77%). This all ended in tears in October 1987 with a stock market crash that saw the largest ever one day fall in the Dow Jones Industrial Average (DJIA).

This provides a useful benchmark to compare against the current USD downtrend. The current trend is just 12 months old and has seen the USD index fall by 12%. Over this period 10-year yields are essentially unchanged while the DJIA is up 29%.

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