The new reflationary mood in markets has seen emerging markets revive and commodity prices soar. However, in recent weeks, rising long-term bond yields appear to be pushing the dollar higher after a long period when the greenback has fallen. Could this appreciation derail the nascent recovery in these markets?
The strength of emerging markets has historically been strongly correlated with a weaker dollar. In a recent report, the Bank for International Settlements noted: “Our analysis suggests that the broad dollar exchange rate is an important risk factor for growth in emerging market economies. Dollar strength is followed by significantly weaker emerging market economic growth on average.”
It found there are a number of reasons why dollar strength and emerging market weakness are correlated, including high dollar government and corporate debt within emerging markets and high foreign ownership of local currency bond markets.
It added: “The role of the dollar as an emerging market risk factor has also been on display since the outbreak of the Covid-19 pandemic. In the wake of the first wave of the pandemic, the US dollar initially appreciated on a broad basis by almost 10% in the first three months of the year, accompanied by record bond portfolio outflows from emerging markets and sharply widening emerging market bond spreads.”
It is a similar picture with commodity markets. Many of the major commodities are priced in dollar terms. As such, commodity prices are likely to move lower when the dollar strengthens to reflect its increased purchasing power. Historically, there has been strong inverse relationship between commodities and the US dollar.
More recently, the prevailing wisdom has been that a climate of economic recovery and the vast $1.9trn (£1.4trn) stimulus package should naturally weaken the US dollar. This is the pattern seen since the end of March 2020, when the US Dollar index (which reflects the value of the dollar against a basket of other currencies) has dropped from 103 to around 90.
However, since the end of February, the dollar has started to gather strength once more, moving back to around 92. The culprit? Rising long-term bond yields, says Neil Staines, portfolio manager at Eurizon SLJ.
“While we believe that rising nominal yields are unlikely to derail the rally in equities or broader risk assets as growth momentum dominates, we are increasingly of the view that against a very strong nominal growth backdrop, rising US yields (both nominal, and more recently real) should be supportive for the US dollar,” he says.
He believes that the growth and yield differential between the EU and US in particular is likely to see the euro weaken against the dollar: “The ECB minutes noted ‘expectations of substantial US fiscal support had led to a steepening of the US Treasury yield curve, which had only affected yields in the euro area to a limited extent, as a significant ‘decoupling’ of yields could be observed’. This is important for the EU recovery but doesn’t help emerging markets or commodity prices.”
Amundi global head of research Monica Defend (pictured) has already identified this as a potential risk. “Rising breakeven and falling real rates have historically triggered a USD sell-off,” she says. “For the time being, we see the USD remaining weak against commodity FX… However, in the second half of the year, this trend may pause, with the environment becoming more mixed for the USD. When breakevens reach the tipping point and fall (and real rates rise), we might see the USD get stronger.”
Much will depend on whether investors believe US inflation will take hold. If inflation indicators continue to pick up, then long bond yields could continue to rise, drawing more investors to treasuries and pushing up the dollar. It is certainly plausible.
BMO Global Asset Management chief economist Steven Bell says: “When it comes to the economic stakes, the US is clearly in the lead… The most recent Composite PMI index came in at a distinctly boomy 58.8.
“The US consumer is sitting on a pile of cash. They haven’t spent the fiscal stimulus and they’re about to get another one. Once they are able to spend it, there’s going to be a massive boom in the US.”
Bell also points out that money supply has exploded and pricing pressures are rising in manufacturing. Higher inflation looks not just possible, but probable.
The dollar is finely balanced. While the consensus remains for continued dollar weakness, there are risks to that assumption. If the dollar starts to strengthen consistently over the next few weeks on the back of higher long-term bond yields, it could derail a number of nascent trends in global stock markets, notably the strength of emerging markets and commodities.
