US Yield Curve Set to Steepen: How Will FX Markets Perform in Response? (3 min read)
There is a growing expectation that the US yield curve is set to steepen again. If it does, how will the FX market perform? In this article, I analyse historical trends to argue that the only consistent pattern is for USD/JPY to rise. As for the rest of FX, their performance depends on the causes of the steepening.
Following the 2008 crisis, there were arguably five sustained periods of US 2s10s curve steepening of more than 50bps: late 2010; late 2012; early 2013; early 2015; late 2016 (Chart 1).
Chart 1: US 2s10s Slope
Chart 2: Correlations (Weekly Changes) of US 2s10s Slope Vs. USD/ EMFX During Periods of Curve Steepening
Above (Chart 2), we’ve highlighted the correlations between weekly changes in dollar pairs and weekly changes in the 2s10s US slope during the five periods. It shows that the 2013 and 2016 steepenings, in particular, saw consistent positive dollar correlations. The 2010 steepenings also saw positive USD correlations, but only marginally. On the other hand, the correlations during the 2012 and 2015 steepening periods were much more mixed. The exceptions were USD/JPY, USD/TWD and USD/CNY, pairings that showed positive dollar correlations across all periods of curve steepening.
The 2015 and 2012 steepenings were driven entirely by back end yields, with front end yields remaining largely flat. EM FX performed relatively well. The 2016 steepening especially saw front end yields move higher by around 65-70bp, underpinned by President Donald Trump’s victory and the promise of reflationary policy, while the steepening moves in 2013 and 2010 saw front end yields around 50bp and 30bp higher respectively.
The figures demonstrate that curve steepening in itself does not necessitate negative EM FX. It has also depended on whether front end yields were largely anchored. This was the case during the 2012 and 2015 periods of curve steepening, but not in 2010, 2013 or 2016.
Chart 3: US 2s and 10s and Periods of Curve Steepening
This pattern is consistent with developments in real yields during the post crisis periods of curve steepening. The chart below (Chart 4) shows the differential between the US 10y nominal yield and the 5y5y breakeven inflation rate over the past 11-12 years. It clearly shows that the periods associated with sustained dollar strength, i.e. 2010, 2013 and 2016, were also associated with a significant rise in real yields, while in 2012 and 2015 real yields were largely flat, and as a result the steeper curve did not result in outright USD appreciation.
Chart 4: Differential US 10y Yield Vs. US Inflation Swap Forward 5y5y
Chart 5: US 2s10s Slope and the DXY (Reversed)
The key takeaway from all this is that a steeper yield curve will drive USD/JPY higher. If we are about to enter another period of curve steepening, then the performance of EM or ‘risk’ FX is dependent on whether or not front end yields remain largely anchored and whether the rise in nominal yields outpaces the rise in inflation.
If steepening occurs where front end yields are also rising, then history suggests shorts in TRY, BRL, MXN, THB, KRW and TWD. Conversely, if steepening is driven by back end yields, leaving front end yields largely anchored, that would, in isolation, favour longs in BRL, MXN, RUB, TRY, AUD, EUR and EUR proxies PLN and HUF. In that scenario, valuation adds to the attractiveness of TRY, BRL, MXN, AUD and RUB longs in particular.
Chart 6: EM REERs - Actual Vs. 20y CMA
Chart 7: DM & EM FX 3m Carry
Henrik Gullberg is a Macro Strategist and has previously pursued Macro Strategy roles at Nomura, Deutsche Bank and Calyon. He can be contacted here.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
Sign up to the Macro Hive newsletter here: