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How the Dollar Has Been Weakened by a Contracting Yield Curve


The US dollar has been the main victim of weak economic data.

Poor US economic data has been the main deterrent to rising interest rates this year. Last Friday, data showed that US nonfarm payrolls grew by 288,000 jobs in April, the biggest increase since January 2012. Meanwhile, the jobless rate dropped to a five-year low of 6.3%. The headline labor-market numbers looked great, but beneath the surface, the civilian participation rate had economists worried.

The labor force declined by 806,000 workers in April, the fourth-largest decline since the Department of Labor began recording the statistic in 1948. Due to mixed results in the labor force and distorted data from winter storms in the first quarter, analysts doubt the Federal Reserve is in a hurry to raise benchmark rates. Although economic growth is expected to pick up in the second quarter, many still believe that underlying weakness is weighing on the health of the economy.

Last December, the Fed began cutting its $85-billion-a-month stimulus program, which led many to think the central bank was ready to tighten policy. The new view, however, is that the Fed hopes to trim the size of its balance sheet without cutting off economic expansion. The current pace of stimulus cuts indicates that the central bank's bond purchases program will end this fall, but it's still uncertain when and if benchmark rates will rise in 2015.

The new view on monetary policy is reflected in the US Treasury yield curve, shown below. The indicator is represented by the ratio of iShares Barclays 1-3 Year Treasury Bond Fund (NYSEARCA:SHY) over iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT). When the indicator falls, it signals that the yield curve is contracting. The curve fell sharply in 2014, just after the Fed announced it was beginning to cut its stimulus program. The move seems counterintuitive, considering the indicator spiked higher in 2013 due to the fear the Fed would, in fact, cut its stimulus program. The decline, however, can be attributed to the market's realization that although the Fed was cutting stimulus, the current economic environment wasn't signaling that inflation was going to be an issue in the near future, thus there would be no need to aggressively raise interest rates.

The yield curve has been steadily trending downward throughout 2014 and is the main reason for weakness in the US dollar this year. The dollar is represented by PowerShares DB US Dollar Index Bullish (NYSEARCA:UUP) in the chart below. The dollar slid to its lowest level in two years on Tuesday as the currency's poor performance has led many traders to back off long bets that were all the rage in January. There's simply a lack of conviction among traders who believe that the Fed, whatever the economic data, will follow up the end of its money-printing with an actual rise in interest rates.

In 2014, Guggenheim CurrencyShares Australian (NYSEARCA:FXA) and Guggenheim CurrencyShares Euro Trust (NYSEARCA:FXE) have been outperformers as their US counterpart has fallen. Although there has been geopolitical strife across the world, the positive correlation between the dollar and Treasuries during times of market anxiety hasn't held as strong as it did in 2013. Investors have put money into long-dated Treasuries, but the end of Fed stimulus seems to have severed the tie between that correlation. Now investors push money into the euro and long-dated US Treasuries as a safe-haven investment strategy. There's little reason to believe the US dollar will garner strength in the near future, which means the euro, Aussie, and Treasuries should remain attractive investment vehicles.

 Andrew Sachais' focus is on analyzing markets with global macro-based strategies. He takes into consideration global equity, commodity, currency, and debt markets. Sachais is a graduate of Georgetown University, where he earned a degree in Economics.

Follow Andrew on Twitter: @MacroInsights
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