Only a narrower interest rate spread in favour of the dollar – which widened this morning.
The ECB initiated its bond buying (QE) programme yesterday. By this morning the German 10 year Bund yields had fallen back by about 7bp to 0.3101% p.a. The 10 year US Treasury Bond yields had also declined by about 4bp to 2.19% p.a. Hence the yield spread between these government bonds widened further and (not co-incidentally) the dollar strengthened against the euro and most other currencies, including the rand, weakened.
The extra yield from the Treasuries would appear irresistible and has clearly contributed to dollar strength, as it has been doing consistently since June 2014. The scatter plot relating daily levels of the euro and the 10 year spread tells the story since January 2014. The negative correlation between these two series on a daily basis is a negative (-0.81) over the period. Spread wider means dollar stronger (and vice versa) would seem a very good bet for now.
What then could cause the spread to narrow and take some of the gloss off the rampant dollar? A recovery in the euro economy would lead to higher yields there. More likely sooner are higher yields in the US, especially at the short end of the yield curve, as the Fed responds to the clear signs of a good economic recovery under way. But the strong dollar itself will add to deflationary pressures in the US as the dollar prices of metals and minerals and commodities recede further, adding to deflationary pressures in the US. Exporters to the US, receiving more local currency for their sales, may well be inclined to offer their goods at lower dollar prices. These deflationary trends may well give pause to the Fed. After all, if inflation and inflationary expectations remain highly subdued why should the FED wish to slow down the economy?
In this way, higher interest rates in Europe and a slower route to what might eventually become more normalised rates in the US, may well reduce the attractions of the US dollar. Until then, the attractions of a wide spread in favour of US dollar determined interest rates is very likely to support the dollar against the euro and perhaps also to add further dollar strength and other currency weakness. Living with a strong dollar rather than trying to compete with it with higher local interest rates, which will slow down other economies, would seem to be the way for monetary policy to go, including in SA.
Prof., What odds would you give on the Fed increasing rates at all in the next 3 months?