Understanding The Yield Curve And Its Impact On The Dollar

| About: PowerShares DB (UUP)

Summary

The yield curve has been steepening globally over the last several weeks.

Spreads have been increasing for US yields versus Japan and Germany.

Thank you to Seeking Alpha for interviewing me on your new interview series.

Opening

I want to start today by thanking Seeking Alpha for giving me the opportunity to be the first person interviewed for the new Seeking Alpha Interview series. It was a pleasure to do, and I enjoyed being able to express my view through words for once as opposed to type. Hopefully, Seeking Alpha will not mind me embedding the video into this article.

Thank you!

FX and Rates

Since we have so much going on over the month of December, I thought today we could focus on both global interest rates and the currency markets at the same time. The schedule this month concerning central banks will be similar to that of September.

Bank Date
ECB 12/8
FOMC 12/13 - 12/14
BOE 12/15
BOJ 12/20
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Busy for sure. Investors, for the most part, seem to forget at times just how interconnected the global financial systems are and how what one central bank does impacts the action of another central bank.

In the video above, I shared my thoughts on how a more aggressive or accommodative ECB could put the Fed on hold. Why would I think that? I mean surely the Fed has all but said they were going to raise rates in December. How could the ECB potentially impact the Fed's action?

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(Mott Capital Management, LLC)

I know you have seen this chart before. It shows us the global yield curve of the US, Japan and Germany. We can see how drastically the yield curve have steepened on the JGBs and German Bonds. It also shows you how the US yield curve (NYSEARCA:TLT) has steepened as well. However, unlike Japan and Germany, the US yield curve has appeared to increase more evenly, whereas in Japan and Germany, you can see how the long end has moved at a much faster pace than the short end.

Click to enlarge

(Mott Capital Management, LLC)

This next chart of the 10-2s shows what I just explained above. We can see the quick steepening in the yield curve in Japan and Germany by seeing the steps higher in the 10-2s, while in the US, 10-2s have remained relatively constant, except for that one bump post-election.

The chart of the 10-10s as I have said before is my favorite graph for exploring how central bank policy around the world impacts one another. Look at the spreads between the US/German and US/Japan 10 years. Beautifully consistent, until again after the election. Then we get a fast-widening of the spread.

Let's take this one step further, say the ECB meets on the December 8th and decides that inflation is still not quite where the ECB wants it to be. It was just this morning that the Eurozone inflation rate came in at 0.6%. If the ECB decided it wanted to step up its efforts and go further into negative territory or is prepared to increase and extend its current QE program, the spread would automatically begin to widen further, right? After all, this would drive the Eurozone yield lower, and even if the US yields just remain the same, the spread will widen. If the Fed then comes in and raises rates, the spread grows even more. Why do we care so much about the spread?

Below is a chart of the Dollar Index.

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(Interactive Brokers TWS)

You can see the Dollar (NYSEARCA:UUP) Index began soaring around the same time we got the bump in yields here in the US and of course the widening of the 10-10s spread.

Here is the Dollar vs. the Yen (NYSEARCA:FXY).

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(Interactive Brokers TWS)

Look at the Yen soar (weakening, an inverse relationship) since the election.

Euro vs. Dollar (NYSEARCA:FXE).

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(Interactive Brokers TWS)

Same thing here.

The spread on yields impacts the Dollar's position vs. other global currency. Why do we care about the Dollar? We care because companies that are US-based that do business outside of the US get a less favorable exchange rate. Our goods become more expensive overseas, and when these companies report the revenue back, their income declines just because of the exchange. Then add on the fact that our products are just more expensive to people outside the US and these people may be less likely to buy them. Lower revenue can equate to lower earnings, which can equate to a lower stock market and a weaker economy.

Additionally, a strong Dollar hurts commodity prices since it would take fewer Dollars to buy the same unit of a commodity.

Gold, down. (NYSEARCA:GLD)

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(Interactive Brokers TWS)

Sugar, down.

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(Interactive Brokers TWS)

Coffee, down.

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(Interactive Brokers TWS)

Corn, flat, but down since the summer.

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(Interactive Brokers TWS)

Deflationary forces at work can be seen in the charts above.

Summary

December will not be a dull month for certain. The fun kicks off this weekend with the Italian Referendum vote on Sunday the 4th. It then continues every week after that until the BOJ caps it off on the 20th. Pay attention to what each and every bank says and the action they take or do not take. All of these banks are intertwined and what one does will impact the others.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Mott Capital Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.