The Relationship Between the Dollar and the Bond Market

The relationship between the relative strength of the US Dollar and its effect on the bond market is important for investors to understand. This is mainly a macroeconomic relationship, although the drivers of supply and demand are not always obvious.

Currency markets are measured by relative value. The appreciation or depreciation of one currency is always in the context of how it relates to a foreign currency. Overall, any currency in its most fundamental form is a means for trade. Therefore, when analyzing the effect of a currency on markets, it is wise to consider it in the context of global trade. Import and export prices fluctuate with relative currency values. If a nation, such as the US, has a net trade deficit, it imports more goods than it exports and consumers will benefit from a strong domestic currency. In the opposite scenario where a country exports more goods than it imports, such as China, producers are better served by a weak currency so their goods remain competitively priced in foreign markets. In this example, as the US Dollar depreciates versus the Chinese Yuan, Chinese exports become more expensive for US consumers to purchase. This effect is undesirable for the Chinese government as their economic growth is dependent on export sales and any reduction in exports would lead to a sharp drop in GDP growth and rise in domestic unemployment.

Stabilization Through Capital Markets Activity
To attempt to control this relationship, the Chinese government engages in capital markets activity to help stabilize their currency. The Chinese Yuan had been pegged to the US Dollar until it was allowed to float in 2005, but since 2008 has once again been constrained to a very tight range and not allowed to fluctuate. China fears its currency will strengthen versus the Dollar and simultaneously impact export demand.

That action is translated to the capital markets by foreign buying of US government bonds – the Chinese government will sell Yuan and buy Dollars to do so. Consistent foreign investment in US government bonds will keep demand high and yields low for treasury paper.

When the trend begins to reverse, however, the snap-back in the currency and bond markets has the potential to be severe. As soon as foreign governments recognize that they can begin relying on a strengthening dollar to support export demand, they will no longer support treasury buying. The US bond market has the potential to face a severe sell-off and rates will be forced to rise.

Who Holds US Paper
To understand how and when that reversal might happen, look at global US treasury reserves. China is the largest foreign holder US debt holder with over $797 billion and Japan is close behind with $731 billion in total holdings. Combined, these governments control over 20% of the US treasury market. If one or both of these nations become net sellers, the US bond market will get slammed. Watch the dollar’s value over the coming months as an indication for possible trend reversal.

Disclosure: No positions