King Dollar Shines Bright

Marios Hadjikyriacos, Senior Investment Analyst at XM.com. An original version of this article can be found here.

King dollar has returned to rule over FX markets. The world’s reserve currency has staged a phenomenal rally in recent months, empowered by the stunning rise in US yields, solid economic fundamentals, safe haven flows, and the absence of any attractive alternatives.

The dollar rally kicked into higher gear yesterday as yields on 10-year US government bonds stormed to new cycle highs, boosted by an encouraging ISM manufacturing survey and Fed officials calling for more rate increases.

Manufacturing activity seems to be picking up after a severe post-pandemic contraction, reinforcing the notion of ‘higher for longer’ rates.

Reflecting the streak of encouraging US data, the Fed’s Bowman and Mester signalled that interest rates will likely have to be raised further.

The 10-year Treasury yield hit 4.70% in the aftermath, its highest level since 2007, as hopes of economic resilience have joined forces with massive government deficits to fuel an exodus from bonds.

Overall, the dollar offers the ‘full package’ at the moment - the highest real rates among the major economies, the strongest economic growth, and protection from market turbulence thanks to its safe haven qualities. With another deluge of US bond supply also hitting the markets this quarter, the ‘high yields, strong dollar’ paradigm could remain in effect for some time.

When bond yields race higher, that usually dampens demand for other assets, as investors gravitate towards the higher returns and safety the bond market offers. It is almost like a gravitational force - the higher bond yields climb, the less attractive everything else becomes.

This dynamic helps explain why gold has been smashed lately. Since gold pays no interest to hold, it inevitably becomes less attractive in a regime where investors can lock in annual returns of 4.7% on US government bonds.

Direct purchases from central banks raising their gold reserves countered this negative pressure for months, but the recent price collapse suggests this marginal gold buyer has now stepped back.

And yet, stock markets managed to defy the gravity exerted by soaring bond yields. The S&P 500 closed flat on Monday, which in itself is a victory considering the steep rise in yields.

But under the hood, there was a striking rotation with high-growth stocks outperforming value shares. That’s a strange tape in a rising-yield environment, perhaps driven by flows at the beginning of the new quarter.

Over in Australia, the Reserve Bank kept its policy settings unchanged earlier today. While the central bank kept the door open to further rate increases, it also emphasised the various risks surrounding the economy, striking a relatively cautious tone.

That hurt the Australian dollar, which fell to its lowest levels in 11 months, with the strength in the US dollar amplifying the move.

The central bank torch will pass to the Reserve Bank of New Zealand on Wednesday. Even though markets assign only a 10% probability for a rate increase, it could still be an exciting meeting as inflation appears to be making a comeback.

An explosion in population growth coupled with record levels of labour force participation are boosting demand, while the depreciation of the New Zealand dollar and rising oil prices could also help to fuel inflation.

Hence, the question is whether the RBNZ will put another rate increase in November on the table. The economic data pulse certainly warrants it, but there’s an election in two weeks, so the risk is that the RBNZ does not deliver any explicit signals to avoid interfering.

On the data front, the JOLTS survey from the US will be an important piece of the puzzle for Fed officials, and by extension, for market participants.