11 March 2021
The relative success of the vaccine rollout in the US has resulted in higher growth expectations versus Europe and other regions. This, in turn, has led to an increasing yield differential, which we expect will continue to push the US dollar higher.
Covid infection rates continue to point downwards in the US, whereas concerns persist about infection rates and further lockdowns in Europe and emerging markets. As a result, according to Consensus Economics, the US is forecast to grow 4.92% over the next year, 0.68% more than Europe, whereas at the start of this year the opposite was true: Europe was forecast to grow roughly 0.5% more than the US (current data as of 8 March). Alongside faster progress with the vaccine, the US is also benefiting from an expected additional fiscal package of USD 1.9 trillion. Together, these factors have contributed to relatively higher US yields and a stronger US dollar. In the medium term, the substantial widening of the US twin deficit poses downside risks to the dollar. The US current account balance has been in deficit for some time but has been relatively stable; however, the Federal budget balance deficit has increased significantly and now accounts for more than 15% of GDP. In the near term, though, we believe the more favourable relative US growth outlook should outweigh this structurally negative fundamental backdrop and support the US dollar.
Yields have risen globally this year, but the US has started to march ahead: the US 10-year Treasury yield of 1.53% is 1.83% above the -0.30% on offer for the Germany 10-year Bund. This differential has increased substantially from 1.48% at the start of the year. As a result, the euro has weakened against the US dollar, from 1.22 at the start of the year to 1.19. The extent to which this trend can continue will likely be capped by how far the yield differential can continue to increase, as well as by the aforementioned longerterm fundamental headwinds for the dollar. We expect that US 10-year Treasuries will be in a 1.625-2% range by year end. However, it’s too early to answer the questions of how quickly the eurozone’s reopening can gather steam, and whether its yields will catch up later in the year. (All data as at 9 March 2021.)
Rates spreads highlight building downside risks for EURUSD
Our proprietary positioning surveys suggest that the consensus is still underweight the US dollar but is moving less short at the margin. At the same time, positioning has been turning against the euro. Looking ahead, we think equity flows could provide the dollar with further support if investors seek to take advantage of the better US earnings growth outlook.
What does this mean for fixed income investors?
The strength of the US dollar this year has been a story of US exceptionalism. Further fiscal stimulus does weigh on the longer-term fundamentals for the currency by increasing the budget balance deficit. However, the extent to which that stimulus has improved the growth outlook will likely mean that it still leads to a stronger US dollar in the near term, as other regions play catch up with the pace of the US recovery. We still appear to be some way from a peak in yield differentials, so we think it makes sense to position for the US dollar to strengthen further versus the euro and other low-yielding currencies. We continue to favour pro-cyclical currencies, typically of commodity-producing economies, for their beta to strong global growth and also their selected strong idiosyncratic domestic stories, but we are moving towards a more neutral view versus the US dollar than we had at the start of the year.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum