Steeper yield curve or stronger US Dollar?

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).

Figure 1

Source: NY Fed, Eikon Reuters

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.

Figure 2

Source: Eikon Reuters

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.

Figure 3

Source: Eikon Reuters

Go long the US Dollar as a hedge against rising uncertainty

In the past few weeks, US equities have shown some signs of ‘fatigue’ amid rising uncertainty over US elections and the lack of stimulus from both the Fed and the government. Most of the rise in risky assets such as equities in the past few months has been mainly attributed to the massive liquidity injections from major institutions to avoid economies from falling into a deflationary depression.

It is interesting to see that in the past year, a cheaper US Dollar has been mainly associated with stronger US equities, especially since the pandemic (figure 1). Hence, the ‘close elections’ may certainly lead to a choppy equity market in the last quarter of 2020 and therefore should result in a strong demand for safe assets such as the USD. We think that going long the Dollar could offer a good hedge against a new round of equity selloff in the coming weeks.

Figure 1

Source: Eikon Reuters

In addition, long the USD remains a contrarian trade as the ‘short Dollar trade’ is still very crowded (figure 1). We are confident that the US Dollar will remain strong if price volatility rises in the near term, especially against risk-on currencies such as the British pound or the Australian Dollar.

Figure 2

Source: CFTC