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Inverted Curves, Carry Trades and the Dollar

What are the implications for the dollar, if any? Over the past 30 years, the US yield curve has almost always occurred during periods of rising interest rates. These included Q3 1978-Q2 1980, Q3 1980-Q4 1981, Q1-Q2 1989, most of 2000 and the current inversion. The only exception was during summer 1998, when the 10-2 yield spread posted a modest -5 basis points as a result of the drying up in capital market liquidity, rather than actual increases in the Fed funds rate. The lack of rate hikes was also the reason why the modest inversion did not precede an economic slowdown or a recession as was the case in other inversions.

Inverted yield curves occur when short-term interest rates exceed longer-term ones, more specifically, when the yield on 2-year notes rises above that of 10-year notes. Yield inversions usually presage economic weakness because they narrow money center banks' profit margins by reducing the difference between interest rates on loans and on deposits. Hedge funds selling short term treasuries and buying long end bonds become squeezed out when the cost of their short-term debt increases relative to their longer maturity holdings. And finally rising short-term rates increase homeowners' interest costs on their floating rate mortgages, thereby reducing the demand for new and existing homes as well as weigh on the value of house prices against which homeowners are borrowing.

Negative yield spreads are also self-enforced when long term yields remain capped by expectations of low inflation, or slowing growth or both. But as Fed Chairman Bernanke and his predecessor Greenspan have postulated, falling bond yields are a result of the savings glut as US-bound capital drives up bond prices.

Although there exists no clear cut relationship between yield curve inversions and the US dollar, recent history has shown a noticeable relation between the latter stages of the inversion and the value of the greenback. The chart shows that the dollar's tendency to decline during the latter stages of an inversion, or shortly after the 10-2 year spread becomes positive. These stages are associated with growing bond market expectations of a looming interest rate cut. Looking at the last two inversions, note the 10% dollar decline during August-October 1998 following the inversion of summer 1998, and the 7% dollar drop during November '01-January '02 following the inversion of February-December 2000. The post-inversion dollar decline may appear as an obvious occurrence due to the impending rate cuts. Yet, it is important to indicate that not all rate cuts are dollar negative as was demonstrated during the rate cuts of 1990-91 and of 2001 when the dollar showed doubled digit rallies.

Therefore, it is advisable to expect incipient dollar weakness once the inversion begins to diminish i.e. well after the negative spread is off its highs, or once the negative spread has disappeared altogether.

During the current yield inversion, dollar bulls must tread cautiously. In addition to the Fed reaching the end of its 2-year tightening campaign, the Bank of Japan has already reached the end of its 5-year old easing cycle. Since both of these forces contribute to the reduction of the dollar's interest rate differential, the ensuing dollar decline could be significant, especially when leveraged players that have piled in the USD-JPY carry trade over the past 2 years rush for the exits.

Rather than waiting for the Fed to begin cutting its benchmark short term rate, look for the inverted yield curve to start normalizing as a precursor to the long awaited dollar retreat.

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