Treasury bond prices and the U.S. dollar have both been falling over the past year. The two markets don’t usually move together in this way. Both markets appear to be responding to strengthening global growth as well as the prospect of rising U.S. deficits—factors that could mean higher bond yields and a softer dollar in the first half of the year.
We continue to suggest investors take a cautious approach to fixed income investments that are long in duration or low in credit quality. However, the low yields in international developed markets relative to U.S. Treasuries don’t provide an attractive alternative.
There is an upside, though. In the longer term, higher bond yields could provide support for the dollar and present an opportunity for investors to add more income to portfolios.
Moving in tandem
In theory, when U.S. real (inflation-adjusted) interest rates rise relative to those in other countries, the dollar should strengthen as investors are drawn to the market offering the most attractive real interest rates.
However, that hasn’t been the case recently. Since early 2017, the U.S. dollar has fallen against a basket of major currencies even though real Treasury yields have been moving significantly higher than those in other developed markets. While we anticipated the rise in bond yields, we have been surprised by the extent of the dollar’s decline.
The dollar declined in 2017 despite widening yield differentials
Source: Bloomberg. Yield spread calculation is based on the difference between the real U.S. two-year yield and the real German two-year yield. A real interest rate is an interest rate that has been adjusted to remove the effects of inflation. The exchange rate is the USDEUR Spot Exchange Rate. Weekly data as of 1/19/18.
Two factors may explain the situation: improving economic prospects abroad and rising trade and budget deficits in the U.S.
The catalyst for the dollar’s drop from a 14-year high in January 2017 was initially the faster-than-expected pickup in economic growth in Europe and Japan. As those economies improve, investors are finding attractive opportunities in those countries. Political concerns—Brexit, French elections, etc.—eased as well, boosting confidence.
While economic growth in the U.S. has also surprised on the upside, the prospect of rising trade and fiscal deficits has been an offsetting factor for the dollar. As a net importing country, the U.S. typically runs a trade deficit. When the U.S. grows at a faster rate than other countries the deficit usually expands. It currently stands at 3.6% of gross domestic product, the widest in six years. To balance the deficit in goods and services, capital from abroad needs to be imported.
A rising trade deficit can pull the dollar down, although it isn’t usually a problem when the economy is growing at a solid pace and real interest rates are relatively high. Foreign investors often find that combination attractive. For example in the 1990s when the U.S. business cycle was ahead of that in other major developed countries, interest rates and the dollar rose.
However, it appears that investors have looked beyond bond yields for investment opportunities. Instead, funds flowed into international equity markets to capture the positive trends in economic growth.
Meanwhile, recent comments from Treasury Secretary Mnuchin about a weaker dollar being “good for trade,” also helped push the dollar down. Calling for a weaker currency would have represented a reversal of longstanding policy. While the administration subsequently backtracked on the idea of a shift in policy, investors may still be nervous about the potential for the dollar to decline further.
Other factors weighing on the dollar and bond prices could include the prospect of growing fiscal deficits and uncertainty about the U.S. government’s trade policies. The new tax law has raised the likelihood of higher budget deficits over the longer term. Macroeconomic Advisers estimates that the deficit will increase to over $1 trillion by 2019, adding to the country’s already high debt/GDP ratio.
Federal deficit as a percent of GDP
Source: Congressional Budget Office (CBO). Federal deficit as a percent of GDP, annual data. Projections shown in chart begin in 2017.
Because the U.S. needs foreign investment to fund its budget and trade deficits, it may require some combination of higher bond yields and a weaker dollar to attract more foreign capital. A weaker dollar allows foreign investors to buy U.S. assets at cheaper prices and higher yields make U.S. bonds more attractive. As deficits grow, upward pressure on yields could continue.
Additionally, as the Federal Reserve shrinks its asset holdings, the market will have to absorb more of the bonds issued by the Treasury. That could add to the pressure on yields. The Treasury Borrowing Advisory Committee estimates Treasury net new borrowing will increase to more than $1 trillion in fiscal 2019 compared to just $519 billion for the 2017 fiscal year.
There is a positive side to these trends. Rising Treasury bond yields present investors with the opportunity to add income to a portfolio without taking increased credit risk. A strategy that allows for the flexibility to invest in longer-term bonds as yields rise, such as a bond ladder, would make sense. Moreover, bond yields and the dollar are likely to stabilize as the Fed raises short-term rates above the rate of inflation. That could happen in the first half of the year.
Remember also that bear markets in bonds haven’t historically been as severe as bear markets in stocks because of the income bonds pay and the ability to reinvest at higher yields. Since 1976, the Bloomberg Barclays U.S. Aggregate Bond Index has generated full-year losses just three times. The last negative-return year was 2013, when 10-year Treasury yields jumped from 2% to 3% in about six months’ time. Even with that rise, though, the loss came to just 2%. By managing duration and credit quality, bonds can continue to play an important role in an overall investment portfolio.
What you can do next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
- Explore Schwab’s views on additional fixed income topics in Bond Insights.