With the Covid-19 pandemic coming under control and the market expects the economy to recover and inflation to pick up, prices of US Treasury bonds have been rising sharply since February. The interest rate of 10-year Treasury bonds rose 1.6 percent at one point, while the interest rate difference between long-term and short-term bonds has hit a high in years. Meanwhile, the US dollar has also had some new movements recently. Last March, the US Dollar Index reached nearly 103 before going down. In January, it hit a low of 89 before stabilizing again and gradually going up. With rising bond yields and expectations of a return of inflation, has the US dollar come to a turning point and moved to an upward cycle?

Because the euro accounts for nearly 60 percent of US Dollar Index, the index is highly correlated with the movement of the exchange rate of the greenback against the euro. The factors driving the medium and long-term exchange rate are the economic development of the US and Europe as well as their monetary policies, meaning the differences in economic growth and interest rates between both sides.

The rationale behind this is that a country with a relatively high growth rate has relatively high potential investment returns. Driven by the objective of seeking profits, funds flow in, and the currency of the country tends to appreciate. When a country tightens its monetary policy, interest rates rise, capital flows in and the country’s currency tends to appreciate, too.

Difference in economic growth can be represented by the difference in the M2 growth rates between two countries, and difference in interest rates can be represented by the actual interest rate difference. The M2 ratio (in US dollar) and the difference in the annual M2 growth rates (in US dollar) between the US and Europe are both highly related to the exchange rate of the greenback against the euro. The difference in M2 growth rates began to widen again in January, a change of the narrowing trend recorded since last April. Meanwhile, the difference between the US and Europe in terms of the interest rates of five-year and 10-year government bonds also took a turn and started to rise in January. The two growth trends are driving up the US dollar against the euro, and they reflect the strong growth of the US economy.

Technically speaking, the US Dollar Index has been through three phases: first, it rose above the moving average; then the moving average went up; afterwards, the short-term and long-term moving averages crossed over each other. All this indicates the US dollar has bottomed out and taken a new turn. Of course, one needs to follow the trend of bond yields to see whether the US dollar will immediately appreciate after reaching a turning point or that it has to consolidate its position and go up gradually.

In fact, with the popularization of vaccination, and as the number of new Covid-19 cases has notably declined, the pandemic in the US has reached a new turning point. Meanwhile, as part of the US$900 billion coronavirus relief package approved by Donald Trump’s administration late last year, the US government has given out each citizen $600 cash subsidy, thus giving consumption a boost. Shortly after the $900 billion package was launched, Joe Biden’s government launched another relief plan on an unexpectedly broad scale, amounting to US$1.9 trillion. The scheme has stimulated the economy and even brought significant inflationary pressure. It also caused investors to worry about the huge amount of US Treasury bonds in the market. As a result, the actual interest rates are on the rise.

With the rate of recovery speeding up in the coming year, coupled with the year-on-year low base effect, and because investors’ speculations on economic recovery have led to a rebound in commodity prices, cost-push inflation will add to the inflationary pressure. Some economists even predict that the core CPI will rise to 3 percent in the latter half of the year, far exceeding the Federal Reserve’s inflation target. They also predict the rate to last for at least one to two quarters.

If the predictions turn out to be accurate, can the Fed still remain patient and maintain the quantitative easing level? As suggested by interest rate futures, the probability of the Fed raising interest rates before March 2023 is 100 percent, while the probability of the Fed raising interest rates in December 2022 keeps rising. If inflationary pressure keeps going up and even show signs of getting out of control, the Fed may buy fewer bonds before the end of 2021.

As with last year, we predict that bond yields will be highly volatile this year. The soaring bond yields of late may be driven by speculators. In the short term, inflation will not soar or get out of control. If it rises sharply, it will go down soon. But in the latter half of the year, when inflation truly takes off and the Fed is under pressure, bond yields will be the first to rise. Therefore, the second half of the year will see the arrival of real inflation and the rise of bond yields, while the US dollar may start to go up in the same period. The movements of the US dollar and US Treasury bond yields, two major factors that drive asset prices, will bring greater uncertainties to risk assets.

(Will Shum Ka-lun, Director of FSM Managed Portfolios & Research )

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