US Dollar Helped by Yellen, GBP/USD Looking Overpriced on Interest Rate Spread Analysis

The Dollar rose against its major rivals after the Chair of the US Federal Reserve Janet Yellen gave a fairly upbeat testimony to the Senate Banking Committee on Tuesday February 15.

Yellen's appearance is the highlight in the Dollar’s diary this week.

Yellen helped the Dollar higher after saying that waiting too long to remove accommodation would be “unwise”, and said that the FOMC will continue to hike rates as long as the economy “continues to show signs of strengthening”.

Going into her testimony, markets appeared geared for less enthusiasm from the Chair in light of slower earnings growth and a higher unemployment rate but instead, Yellen remained committed to the Fed's plans for tightening and said rate increases in 2017 are appropriate.

“A tone from Janet Yellen suggesting a little more eagerness to get on with normalising interest rates sent the US Dollar to fresh highs for the day and knocked interest rate-sensitive markets including stocks and gold off their perch,” says Jasper Lawler at London Capital Group.

The Pound to Dollar exchange rate fell towards the bottom of its recent ranges on the comments and in the midweek session is quoted at 1.2457 on the inter-bank market. The Euro to Dollar rate is meanwhile at 1.0575.

GBP/USD has Further to Fall

Yellen also warned of uncertainty under Trump, saying that “economic and fiscal policy face an uncertain path under the administration of Donald Trump”.

This is the second time that a high ranking Fed official has warned about the current administration’s economic plans, after Stanley Fischer voiced something similar last week.

“We think that the Dollar may also benefit from these comments, as it suggests that the Fed is not frightened of criticising the Trump administration, and thus asserting its independence; in the current environment this is Dollar positive, in our view,” says Kathleen Brooks at City Index.

The yield on US government bonds has risen higher as a result of the testimony and Brooks warns that the Pound to Dollar exchange rate is now looking overvalued as a result.

While US yields rise, the UK’s yields are actually declining, something that favours flows of capital from Pounds into Dollars.

“The spread between UK and US Treasury yields fell three basis points on the back of Yellen’s comments, and the spread is back at its lowest level since the end of December, see chart below. Back then GBPUSD was trading around 1.2250, so the yield spread could indicate further GBP weakness this week,” says Brooks.

However, the markets will want more concrete hints regarding future interest rate rises in order to push the Dollar notably higher.

Although the Fed has three rate hikes in the dot plots this year, the market is currently pricing just two, so any hawkish hints could drive Treasury yields and the Dollar higher.

"Yellen gave no clear hint of a rate hike already in March. We continue to go for a June hike. The Fed chair also supported the view that the Fed’s main policy tool will remain the fed funds rate, not its balance sheet," says Johnny Bo Jakobsen at Nordea Markets.

Nordea stick to their forecast of two Fed rate hikes this year, with the next move in June.

Jakobsen argues moderate economic growth and well anchored longer-run inflation expections allow the Fed to wait a bit longer before making the next move.

 Morgan Stanley: Dollar Strength to Return

A lack of trends in the foreign exchange market appears to have put investors off the USD recently with the broad-based US Dollar index (DXY) fading in strength since the start of the year.

“The momentum in the USD trade appears to have waned in the absence of any new Fed-driven catalyst," notes foreign exchange analyst Dara Blume at Morgan Stanley.

Above: The Dollar basket tends to follow expectations for future interest rate rises at the US Federal Reserve

Blume argues main thing holding the Fed and markets back from expecting another rate hike soon is uncertainty around the fiscal boost and the impact this will have on long-run inflation.

It is noted US inflation expectations as measured by breakevens continue to trade within a range and have even come back from their highs after Friday's payrolls report.

"We think that a continued improvement in US economic data and a Fed that acknowledges this should push the USD back into its uptrend," says Blume.

Morgan Stanley acknowledge a major risk to their current bullish view on the USD is a scenario of the Fed keeping real rates extremely low for a long period of time, even in a rising inflation and growth environment, which would steepen the US yield curve.