In the past few months, we argued that the rise in uncertainty over inflation expectations and economic output will certainly levitate the term premium and therefore steepen the 2Y10Y yield curve. For instance, figure 1 (left frame) shows that the US 10Y term premium has historically strongly co-moved with the unemployment rate and that the deterioration in the job market amid strict lockdown measures could lead to higher long term yields. Figure 1 (right frame) shows that the sharp yield curve ‘steepener’ that occurs prior or during economic recessions is mainly coming from the dramatic rise in the term premium.
Even though we do not expect the 2Y10 yield curve to dramatically steepen as during the Great Financial Crisis (by 3 percent), we still see a higher retracement on the 2Y10Y towards 1% (currently trading slightly below 70bps).
At the same time, we are also bullish on the US Dollar as a hedge against rising uncertainty over a range of macro events (US elections, Brexit, new lockdowns imposed by governments…). In the past 18 months, it is interesting to see that a cheaper US Dollar has usually coincided with higher equities (SP500) and vice versa (figure 2); therefore, we think that being long the US Dollar at current levels offer investors a good hedge against a sudden reversal in equities.
However, the question now is: can the US Dollar appreciate as the yield curve continues to steepen? Figure 3 shows an interesting relationship between the greenback and the 2Y10Y in the past 15 years; a steeper yield curve has generally been associated with a cheaper US Dollar and not a stronger USD.