Why Higher Fed Rates Haven’t Helped the Dollar

John M. Bland, MBA, co-founder,

USD Not Responding Positively to Higher Fed Funds Target The prospect of a tighter Fed policy during the second half of 2017 and into the new year has not been providing the USD with the support that we might have expected. We have been scratching our heads about this since forex markets usually are driven by short-term interest rates. The Fed has increased the top end of the range on Fed funds by 100 bp from early December 2016 until the final FOMC meeting of 2017. In the same time period, the yield on the 10-yr yield has been virtually unchanged from 2.43% from just after the December 2016 FOMC meeting to 2.44% late Wednesday, on January 3, 2018.

Two-Year Note Slow To React To Tighter Fed Policy The chart above shows rates for just beyond a year for the top end of the Fed’s 25bp target range for Fed Funds (red), the yield on the two year note (green) and the 10-year note yield (grey). Note that the two year note was relatively slow to react to the rising Fed Funds rate which started just over a year ago. Some use the yield on the 2-yr note as a proxy Fed Funds target forecast. Note the 2-yr finally started to play catch-up to Fed Funds in the final quarter of 2017. More remarkable has been the flatness of the 10-yr yield in this period. While the Fed has a measure of control over the yield on the 2-yr yield via its Fed Funds target range, the 10-yr yield is more a reflection of what investors are expecting for economic growth and inflation than to the current Fed Funds target.

Sharp Decline In 10-yr Minus 2-yr Spread Signals Market Uncertainty? The second chart just above shows the 2-yr note yield (green), top of Fed Funds Target band (red) and the 10-yr Note Yield minus the 2-yr note yield (grey). The grey line falls as the yield on the 10-yr declines RELATIVE to the 2-yr yield. Our main focus is in the differential between the two yields. A falling of the differential implies that investors expect that long term rates will be lower than short term rates in the future. Typically this is because they are expecting a slowdown in the economy. However there are special factors at work at the present time that could be holding back long term rates due to the Fed’s quantitative easing program which took a lot of term paper out of the market. It is my view that the USD has reacting negatively to the decline in the 10yr-2yr spread more than the rising Fed Funds rate. If you are trading in the USD, you ignore this relationship at your peril.

Amazing Trader EVENT RISK Calendar:

Tue 9 Jan 2018

15:00 US- JOLTS Survey

Wed 10 Jan 2018

09:30 GB- Output & Trade

15:30 US- Crude

Thu 11 Jan 2018

13:30 US- PPI & Weekly Jobless

Fri 12 Jan 2018

13:30 US- CPI & Retail Sales

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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