U.S. Treasuries Vs. U.S. Dollar: Get The Regime Right!

|
Includes: ERO, EUO, FXE, UDN, UUP
by: Evariste Lefeuvre

Summary

The U.S. Dollar is rising and should continue to increase across the board.

For investors, the correlation regime with U.S. Treasuries matters a lot.

Between 2011 and 2013, a stronger dollar would come along with lower U.S. Treasury yields.

The sign of the correlation has changed since: a stronger dollar will bring along higher U.S. Treasury yields.

I don't expect any change in the correlation regime before the Fed starts hiking next year.

After a small pause, the DXY is rising again, helped by the combination of weaker data in the Eurozone, expectations of a more aggressive ECB and a higher level of risk aversion. Flight-to-quality episodes are generally characterized by the combination of a stronger dollar and lower U.S. Treasury yields. This is a temporary breach in a correlation that tends to be either nil or slightly positive.

The chart below shows yet that, over the past few years, the correlation has registered two different, and opposite, regimes. Today's correlation remains positive, as it has been since the announcement of tapering, even though the ongoing selloff in stocks is taking its toll.

Here I focus on the possible implications of a stronger USD on U.S. Treasury yields. Implication might be too strong a word since it implies causality. Yet, the correlation between the USD and U.S. Treasury yields is not stable. If you want to know where U.S. Treasury yields might be once the US Dollar has strengthened (which is clearly today's crowded trade), you'd better get the regime right.

The main question at this stage is what drives regime switches.

I start with intuition. The chart below shows that periods when the correlation between the US Dollar and U.S. Treasury yields is highly positive (above 0.45) occur when there is growing uncertainty on the forthcoming pace and path of monetary policy (either the end of a tightening cycle or the beginning of an easing phase). Interestingly enough, the correlation is barely significant in the middle of a monetary policy cycle.

This leads to my first conclusion: if you are long dollar you would rather be short U.S. Treasures until the Fed starts tightening, because the correlation between the dollar and U.S. Treasury yields is at its highest in the months before and at the beginning of the tightening.

Then I try to identify the macro and financial factors that may influence the changes of the rolling correlation between the USD and U.S. Treasury yields. The table below presents ex ante expectations for the signs of each factor:

The chart below presents my estimate of the 6-month rolling correlation of DXY/U.S. Treasury yields based on the factors above (to which added the historical standard deviation of TIPS breakevens).

The model performed very well until mid-2011 and has since marginally failed to track the upswing in volatility. Including changes in the Fed's balance sheet (proxy of quantitative easing policies) did not increase the explanatory power. The current reading might be disappointing but it suggests that, at least, the correlation regime should be positive.

Looking forward, I use the inputs listed above to try to forecast the correlation regime of the next few months:

i. The Eurodollar slope has already steepened sharply. There is still some upward potential but the contribution to the correlation should wane while we are getting closer to the first hike (as can be seen below, the money market curve flattens when the Fed starts hiking);

ii. VIX is expected to edge up only slightly. As can be seen below, it is highly dependent on the dispersion of growth expectations/forecasts ahead. I don't expect any significant dispersion "break" within the next few quarters as the consensus for a solid growth momentum in the U.S. is quite high.

iii. Eurodollar historical volatility remains low and should therefore increase over the next few months as the timing and speed of monetary easing remain uncertain.

iv. Oil prices should remain flat or increase somewhat (geopolitical risk). This may not change the big picture for the correlation regime.

If we summarize, the correlation regime should remain positive for a while but might weaken as we are getting closer to the first Fed hike.

Bottom Line: I have identified several factors that appear to be robust in explaining the behavior of the correlation between the U.S. dollar and U.S. Treasury yields. The forthcoming trend for the Eurodollar curve, the VIX and oil prices should not bring about a regime shift before the Fed tightens. But, as shown in my historical charts, the correlation tends to weaken when the Fed is in the middle of an easing or tightening cycle. Therefore, if you are long dollar you'd rather be short U.S. Treasury bonds until the Fed starts hiking.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.