MBS Live Day Ahead: So You Want To Talk About The Dollar vs Rates?

Today is shaping up to be one of those days where we start off with a large overnight bond market movement followed by a rush of attempted explanations that don't quite pass muster.  This happens from time to time.  Market participants have a strong drive to connect the dots between cause and effect.  But that's not always possible or at least not always clear.  Still, that doesn't stop market participants from trying.

I won't be trying TOO hard this morning.  I figure it's more worthwhile for you to know when things are clear and when they're cloudy.  I also have more personal trust in my cohorts who aren't shy about saying "I don't know what's going on."  That makes me pay more attention when they're seeing clearer connections.

As the title suggests, the explanation du jour for overnight bond market weakness is "a weaker dollar."  The thinking is that a weaker dollar dissuades foreign investment in the US bond market (or that it simply creates inflation) thus pushing rates higher.  Combine that with with Trump's increase on certain tariffs yesterday as well as overnight comments from Treasury Secretary Mnuchin on the benefits of a weaker dollar, and this is a pretty compelling little narrative.  Unfortunately, it has a fair amount of competition.

If you can pick a line out of the chart above and clearly say "yep!  That one is leading the others," power to you.  As is so often the case in financial markets, it's probably not a case of ONE factor driving the others.  After all, markets are big.  There are several major classes of traders in bond markets  with different goals, requirements, trading hours, amounts of capital/leverage, and amounts of "friends" to trade with.

Even if you want to say the dollar is the best explanation of those available, you might be interested in at least one counterpoint that I think is pretty obvious.  We'll start with a more recent view of the dollar index, US rates, and EU rates.  For what it's worth "Germany 10yr" is the same thing as "EU 10yr" because Germany is the biggest component of the EU economy and banking system (among other things).  Also note that I've inverted the dollar index (higher line = lower prices) because that's the correlation people are arguing this morning.  In other words, they are saying the yellow and orange lines should be following each other.

The previous chart speaks for itself (seriously, there are captions!).  But just to reiterate, the point there is that the bigger, more abnormal move overnight was seen in European bond markets.  That's a clue we'll come back to momentarily.  

The next chart just focuses on 10yr yields and the Dollar.  The lower pane is much longer-term.  The upper pane shows that the dollar/rates argument being made today completely falls apart depending on when you're looking.  It's an explanation of convenience today with inconvenient precedent.

The lower pane of the chart isn't intended to make the same case as the upper pane.  By the time we meditate on the upper pane, we can accept the fact that currencies have sufficiently unique inputs as to not have a direct correlation with rates (at least not direct enough to explain rate movement over shorter time horizons).  But in considering some of the currency inputs, we may paradoxically connect several of the dots that seemed to be random until now.

As the chart suggests, there are several clues in the lower pane.  If you want to try to guess what they mean, do it now, because I'm about to tell you in the next sentence!

When the Euro was officially rolled out in the early 2000's, the result was a massive weakening of the dollar.  I included that section of the chart to reinforce the fact that so much of the dollar's movement is dependent on foreign currency valuations.  Big moves in the Euro and Yen do as much to influence the dollar as anything.

We got another great example of this heading into ECB QE in 2015.  ECB QE had a clear implication of a weaker Euro.  The weakening Euro caused massive strengthening in the US Dollar (Japan wasn't hurting the dollar with their own QE either). 

Now here's the magic decoder ring for all of the above: tomorrow is an ECB Policy Announcement Day.  That means Draghi might drop some faint hint about the strengthening EU economy and prospect for eventual exit from stimulus measures--something that would strengthen the Euro and hurt the dollar.  Much of the past 2 days of trading has simply been a pricing-in of that risk, but it was overshadowed yesterday by the Bank of Japan announcement and press conference.

Bottom line, it's not impossible or even unlikely that the news being discussed is having some sort of effect on markets and bonds, but as far as I can see, the Euro/ECB angle is a better case to be made.  Beyond that, bonds have simply been in an ongoing trend toward higher yields and one of the options for yesterday's rally was to view it as a mere correction within that broader negative trend.  Ultimately, today's losses haven't covered any more ground than any of the 3 weakest days last week.

The potential flashpoint on the domestic econ calendar today is the 5yr Treasury Auction at 1pm.  This will give markets a better sense of how traders are feeling about the yield curve because it can show some contrast to yesterday's 2yr Treasury auction (which was stellar, but focused on the short end of the curve).