USD Role in Yield Stocks Relationship

As FX, equity and bond markets become increasingly impacted by asset purchases and liquidity injections from the world’s major central banks, the relationship between global bond yields, US dollar and stock indices becomes a little more complex, but not impossible to grasp. It may be misleading or inaccurate to speak of the US dollar in general terms without specifying against which currency. In this case, we focus on the US dollar index, a basket of six currencies (euro, Japanese yen, British pound, Swiss franc and Swedish Krona). The index is also a proxy for EUR/USD exchange rate as it occupies 57% share in the index.

Prior to the credit crisis and the decline in inflation trends, stock traders were trained to believe that bond prices are generally inversely related to stocks, meaning that yields and stock prices usually move in the same direction. The rationale being that rising economic growth drives stocks higher, while yields move upward in anticipation of inflationary pressures resulting from improved growth. For forex traders, no mantra can be applied in such general fashion because foreign exchange rates tend (not always) be influenced by yield differentials between two nations rather than absolute yield behaviour.

Looking at a chart of the outbreak of the 2007-8 financial crises, equity indices fell alongside bond yields, with the dollar benefiting as deep deleveraging and sharp market losses eroded global growth and reduced inflation. Money exited commodities, higher yielding instruments, seeking refuge in the US dollar, primarily in the form of cash (treasuries). Once global central banks stepped up their liquidity operations in Q1 2009 (box 2) to stabilise financial markets and help out banks via quantitative easing from the Federal Reserve and Bank of England, stocks rallied by over 50%, causing a rebound in bond yields due to improved global economic conditions and the threat of inflation. This pushed money away from the USD-denominated cash and into higher growth commodities, their faster-moving currencies and emerging market equities.

In January 2010, when the Fed’s quantitative easing expired, the stimulus ran out of the markets and equity indices began to suffer at the benefit of the US dollar (box 3). These moves were especially exasperated by tensions in the eurozone (Greece, Portugal and Ireland credit rating downgrades). The US dollar was also supported by improved economic data in the US, while global bond yields fell in tandem on renewed worries of economic growth, this time on fears from the then nascent eurozone debt crisis.

By late summer 2010, markets licked their wounds from the onslaught of credit rating downgrades in the eurozone and the flash crash in May 2010, prompting the Fed to go for additional stimulus via the announcement of QE2 in November 2010. The anticipation to the announcement had built up earlier that summer, triggering a fresh run-up in US and international equities.

The cycle continued when the Fed’s QE2 ended in June 2011 and raised questions about the need for QE3. Markets were not pleased with the eventual announcement of operation twist, which involved buying and selling similar amount of short and long term treasury paper, hence no extra liquidity as was the case in outright purchases in QE1 and QE2. This is seen via the decline in yields and the sell-off in equities suffering from escalating risks in the eurozone, evidence of a slowdown in China and rest of BRICs.

The rally in global equities between January and mid-February resulted from a stealth combination of central bank liquidity (ECB offered nearly €400 billion in 3-year money at 1.0% to eurozone banks, Fed said it would extend zero interest rate policy into 2014 from previously stated 2013 and Bank of England entered QE3 with an additional £50 billion in fresh asset purchases).

Going forward, we view the Fed unlikely to continue shoring up confidence by simply restating rates will remain “exceptionally low” until 2014. Once the recent US data improvement cools off (due to mixed performance in BRICS, impact of high USD on US equities and eurozone sluggishness/recession), demands for US QE3 will likely escalate via a selloff in equities as was the case in Spring 2010 and summer 2011. This would translate into falling bond yields, and rising USD.

USD bulls, however, must be warned from an uninterrupted expansion in Asia, more specifically China, which will likely maintain the buying-the-dips in the Aussie and Canadian dollar via robust commodities. Thus, to avoid this risk, USD longs are more suitable against the euro and the Swiss franc.