USD: Why have Treasury Yields Fallen Since the FOMC; How Could this Affect the Dollar?

An out-of-keeping fall in U.S Treasury yields since the FOMC has led analysts to delay their expectations of the pace of Fed tightening in 2016. 

10-year Treasury yields have fallen to 2.162, at the time of writing, from a peak of 2.332 on the 16th, the day of the FOMC - an unexpected non-correlation.

Some analysts are suggesting this is because the market is more dovish about the trajectory of future Fed hikes than the Fed itself: 

DailyFX Strategist, Illya Spivak, says the market is now only pricing in two rate hikes, versus the FOMC’s four. 

“Investors’ priced-in bets envision two rate hikes next year, whereas Chair Yellen and company expect to issue four. This means that markets may be more sensitive to an upside surprise that forces re-pricing of dovish bets versus the alternative." 

Today’s 3rd quarter GDP revisions may proivide that surprise, especially if they are higher-than-expected, and would lead to renewed upside for the dollar.

Consensus expectations are for a slow-down to 1.9% from 2.1%.

Personal Consumption Expenditure – the Fed’s preferred metric for measuring inflation - is also scheduled for release on Tuesday and is expected to remain at 1.3% in Q3.

Again a higher result could lead to dollar gains.

Bond Market Ruffle

According to Richard Perry, Market Analyst at Hantec, weak global growth could be a reason why bond prices are acting strangely:

“Since the FOMC meeting the U.S 10-year Treasury Yield has fallen. For me this is a signal that bond markets are concerned over the lack of growth (or I suppose global demand) and the Fed will not be able to hike as quickly as the FOMC dot-plots would have you believe,”

Given yields would normally be expected to rise following a rate hike, the fact that they have fallen suggests traders don’t see the Fed adopting as steep a hike trajectory as the FOMC indicated.

Perry goes on to suggest a rise in longer-dated debt, like 30-year bonds, indicates bond traders don’t think it is likely that the Fed will adopt an aggressively hawkish stance in 2016:

“Bond traders continue to see value in the longer end of the yield curve despite the Federal reserve tightening on Wednesday. 

If traders are willing to buy longer-date debt, this would suggest bond markets are not expecting the FOMC interest rate to rise especially fast in 2016.” 

Perry thinks the dollar could lose momentum over the holiday season: 

“I tend to view dollar strength as a bit of a knee-jerk reaction which could settle down in coming days.

“The trouble is that with the holiday season driving down volumes price volatility can be elevated.

“However as new year kicks in I believe traders will have had time to reflect on the dovish FOMC, that is going to have to massage down dot-plots in the coming meetings.

“The U.S 10-year is already falling suggesting bond markets are still viewed as attractive despite the rate hike.

This could mean a choppy dollar in coming weeks and months.”

FOMC forecasts for 100pbs out of whack?

Perry’s view that the FOMC may need to “massage down dot-plots in coming meetings,” chimes with those of several other market analysts, who are also sceptical that the Fed will follow through on the current consensus amongst its members for 100 bps of rise in 2016.

Laurence Mutkin, chief interest rates strategist at BNP Paribas, for example, points out that 100 bps of hikes would probably mean the Fed raising rates four times in 2016, assuming 25bps per rise.

Given the FOMC would probably want these rises accompanied by a press conference, and given that there are only four meetings which are accompanied by press conferences in 2016, it would indicate one rise every time there is a press-conference. 

Mutkin sees this as unlikely, however: 

“Our central case is that they (the Fed) probably don’t get to do four (rate hikes) next year, probably sometime in the middle of the year the rising dollar and interest rates will start to impact and the economy will start to show signs of slowdown, and they might ‘skip’ somewhere in the second half of next year.”

Analysts at Deutsche Bank also see a mid-year pause, as well as a cumulative 75bps of rises during the whole year:

“Our economists believe the Fed will hike rates by 75bps by the middle of 2016 – and then pause of the rest of the year.” Says the research note from Deutsche.

Seasonal strength in stocks could weigh on dollar

Research appears to back up the existence of an observed seasonal bias towards strength in stocks in the run up to Christmas – also known as the 'Santa Rally' - which may also indicate a possible bout of weakness for the dollar around the same time, since equities and the greenback are inversely correlated.

This could be further evidence that that dollar may be in for a not so merry Christmas, or even a happy new year.

However, more importantly, the growing fissure between the FOMC’s expectations and those of leading market analysts, as well as the oddity of the fact that demand for bonds remains strong even following the FOMC's first rate him hike in years, could presage a correction in the dollar, as markets reintegrate expectations with 'reality'.