As the GDP number was released, we saw the Dollar index ($DXY) trade a mix of up, down, then sideways as well as the 30Y US treasury bond trade trade up, down, sideways. We saw no apparent correlation, so then we talked through the macros of it. After a brief conversation, we came to no definitive conclusion so I decided, as all good traders should, take a deeper look.
So an US Treasury bond, bill, or note is essentially a promissory note that the US Treasury issues to an investor in exchange for a loan. Upon maturity, the government will pay back the principle on the loan plus the accrued interest. As demand outpaces supply for these Treasury bonds, the price increases, decreasing their yield upon maturity (aka the interest payed). In the world of finance, a lower yield on any sort of loan typically expresses the sentiment that there is lower risk associated with potential default on the loan.
What does that mean for the dollar? So as the yield on US Treasuries go lower, this implies higher confidence in the ability for the United States to pay back its debts and, overall, properly manage its finances. A foreign investor looking to diversify their FX holdings could think, "Hey, it looks like the US government has got their stuff together, the dollar might not be a bad place to park some of my money." So a trader or fund manager, say in London or Germany or what have you, would sell some of their native currency to buy some USD. As more people pile into this trade, the dollar increases in value relative to other currencies.
This kind of trade makes sense from a practical point of view. Would you currently want to swap your currency for Saudi riyals with the price of crude oil crashing? Assuming, Greece wasn't on the Euro, would you want swap your dollars for their native currency or buy their government bonds?
This chart illustrates from the period between 2008 and 2015 a nice visual correlation between 30Y Treasury yields and the Dollar Index. As yields on US Treasury securities decreases, the dollar becomes a more appealing currency and thus the value rises. But as with finance, things are never that clear and simple. Take a look at the next chart comparing the Dollar Index with the 30Y Treasury Note on a much larger time scale.
Take a close look at that period in the 1980's where the dollar rose to its enormous highs while the yield on the 30Y subsequently also rose. Why would the value of the dollar rise if investors perceived an increased risk in UST bonds?
In the early 1980's president Reagan ran a huge budget deficit while concurrently tightening the money supply. So let's think about this one in the simplest terms possible. The government was spending money they didn't have while also tightening the amount of US dollars available. As an investor, why would I want to loan the government money if, first of all, they were broke and deciding to spend even more, while also supporting monetary policy that would make cash even less available? If I decided to give the government a loan, would there even be the cash available for them to pay me back with interest? The prospect of there simply not being enough cash available for a government to pay back its loans seems absurd, but on a side and perhaps relevant note, I would like to point out that the Illinois state government is currently issuing IOUs to its lottery winners.
Naturally, yields on US Treasury securities rose since no one wanted to lend the government money. And if US Treasuries are what we use to base the standard of the "risk-free rate", banks would be even more reluctant to lend out money to the general public. With everyone hoarding their dollars and the central bank tightening the amount of these dollars available, we saw an appreciation in the value of the dollar despite yields on the government bonds rising.
So now we arrive to the answer for the title of this post. US Treasury Bond yields and the dollar do experience periods of close correlation and that correlation can last quite a while. In the current global climate of quantitative easing, ZIRP, and easy money policy, we have generally seen a negative correlation between the yields on the US 30Y bonds and the DXY dollar index. Similarly, we have seen a negative correlation between the S&P500 and 30Y yields. But for those of you who have been paying close attention, those correlations have been starting to shift underneath the surface on even the slowest and dullest days of trading. For less astute traders, it was just a slap on the face on a couple of days, namely, October 15th, 2014 and August 28th.
Stay spry and keep your powder dry.
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