Nolan Stanton

Market Commentary

For the week ending 23 February 2018
Report by Nolan Stanton
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Nolan Stanton


What gives with the US Dollar currently? The yield on two-year US Treasury bonds has risen above levels prior to the Great Financial Crisis of 2008, which compares extremely favourably to the two-year duration German (Euro) Government bond yield, UK (Sterling) gilt yield and Japan (Yen) Government bond yield, but all three currencies have rallied against a falling Dollar since Autumn. One argument has been the decline in appetite for the US Dollar, reflects investor fears that the Federal Reserve is ‘behind the curve’ on increasing interest rates as the prospect for inflation increases. However, the current gap between the US consumer price index (CPI) and US interest rate is, as the Bank of New York highlight, hardly particularly Dollar negative given that it stands about 0.5% narrower than the average of the past ten years. This suggests that some other factor is increasingly having an impact on currency markets across the world.

Interestingly, the emerging signs of a change in the paradigm driving currencies occurred firstly not in the US Dollar, but the Pound Sterling. When the 2016 Referendum was announced on the UK’s EU membership, the link between yield (rate of interest on short dated government bonds) and the performance of the Pound, against the Euro and Dollar, became increasingly tenuous. This is particularly apparent when considering the action of the Euro/Pound rate. Between the start of 2016 and Autumn last year, the yield gap between two-year German Government and UK Government bonds remained stable. However, despite this, Sterling came under increasing pressure in the run up to June’s Referendum. Even the sharp rise in the two-year gilt yield, since Autumn, has had a minimal impact on the Pound’s value against the Euro, which is unchanged over the subsequent five months. It can be argued therefore that political uncertainty, created by Brexit, is the key determinant for the Pound’s value on foreign exchanges. Further evidence, of the impact of political uncertainty on currency values, can be seen with the Euro and how its value changed from the point Macron appeared to be taking the French presidency as opposed to Le Pen. Since then the Euro has risen around 15% against the US Dollar, despite a significant gap opening up between the return (yield) on two-year US Treasury bonds versus German bunds of a similar duration.

Given this evidence it would suggest that attention needs to be paid to next month’s Italian elections, which could upset the political balance in the EU currently. Also, it highlights that the currency markets may not be paying sufficient attention to domestic political developments around Brexit in the UK. Finally, it indicates that the continued monitoring of political developments in Washington and elsewhere seems sensible.