U.S. Dollar Is The Winner Of The Battle Of The Central Banks

by: John M. Mason

Both the Federal Reserve System and the European Central Bank made announcements this week concerning the future policy rates of interest in their respective realms.

Investors picked up right away the fact that the gap between European short-term rates and US short-term rates would increase, even substantially.

Bond markets had very little reaction other than the fact that the term structure became flatter, longer-term rates remaining actually declining slightly.

Thursday, the US dollar achieved its biggest one-day jump in 18 months. Investors took a look at what the Federal Reserve is planning and what the European Central Bank is planning and said “Buy the dollar!”

Against the Euro, $1.1565 could now buy one Euro, down from over $1.1800 earlier in the day. The reason? Investors saw a bigger gap emerging between the US and European central banks.

The ECB statement on Thursday indicated that it would end its bond buying program by the end of 2018 but added that it was unlikely that there would be any rise in interest rates before the end of summer 2019.

The Federal Reserve clearly stated on Wednesday that it intended to produce two more increases in its policy rate this year, and, this would be followed up by three more increases in 2019.

What a difference… and the markets reflected it.

But, the dollar did not just grow stronger against the Euro.

The US Dollar Index (DXY) ended the day around 94.85, the highest it had been since May 29, 2018, and the highest it has been since late October 2017.

Emerging market currencies almost all seemed to be under pressure.

The expectation of rising short-term interest rates seemed to have already been built into longer-term interest rates as the yield on the 10-year US Treasury note actually dropped a couple of basis points.

On Wednesday, the yield on the 10-year closed at 2.978 percent, whereas on Thursday, this yield closed to yield 2.938 percent.

This assumption about the increase in rates being built into the longer-term US Treasury notes is supported by the fact that the yield on the longer issue actually declined by more than the short-term end declined, resulting in a term structure of interest rates that became even flatter. The term structure is the flattest it has been now for quite a few years.

Right now, there is less than a 50 basis point difference between the yield on the 10-year Treasury note and the yield on the 2-year Treasury note.

The rise in the value of the US dollar, therefore, did not come from the fact that the Federal Reserve expects to continue raising its short-term policy rate through 2019.

No, the market response as far as the dollar goes is a response to the announcement of the European Central Bank today relative to what was announced by Federal Reserve officials yesterday.

So, it looks as if we have a US dollar that will be staying strong or getting stronger for the near term. What this will do to events in Europe and to the currencies of emerging nations will be a part of the evolving story.

Whatever, the US dollar remains one of the stronger currencies in the world. Not as strong as it was when Donald Trump was elected president in November of 2016, but still one of the strongest ones.

This may really give us a picture of how the Federal Reserve is the central banker to the world.

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.