Rising yields could turn toxic for U.S. dollar

By Wanfeng Zhou – Analysis

NEW YORK (BestGrowthStock) – The recent jump in Treasury yields has been a boon to the U.S. dollar, but that could change rapidly should higher rates bring U.S. debt worries to the fore and threaten the nascent economic recovery.

Yields on benchmark 10-year Treasuries edged near 4 percent last week after tepid demand for $118 billion debt auctions stoked fears over the burgeoning U.S. deficit.

Rising rates typically benefit the dollar as they make U.S. assets more attractive. Indeed, the dollar-yen pair hit a seven-month high on Thursday as yields rose again.

But perception is key here. The economy is still fragile, and the federal government is set to borrow $1.6 trillion this year. Another jump in yields could turn toxic for the greenback, especially if it coincides with a rise in the price of U.S. credit default swaps, which would suggest a growing discontent with the U.S. fiscal situation.

“If higher yields become more squarely perceived as driven by a broader credit issue, it becomes U.S. dollar negative,” said Alan Ruskin, head of currency strategy at RBS Global Banking & Markets, in Stamford, Connecticut. “We are not there yet, but we could flip relatively quickly.”

Heightened worries about U.S. sovereign credit risk could hit dollar assets across the board. Last May, U.S. equities, Treasuries and the greenback sold off simultaneously after a cut to the U.K.’s credit rating outlook sparked speculation the United States may face the same predicament.

The heavy flow of new government debt supply is starting to weigh on bond prices. This was particularly evident in the interest rate swaps market where U.S. debt, for the first time ever, briefly traded at a discount to private-sector credit. This had spurred chatter that the U.S. government is perceived as riskier than banks.

“Finally, the market has started to question the U.S. fiscal policy, the passing of the healthcare bill and how this will affect the balance sheet of the U.S. government,” said Jonathan Xiong, a director and senior portfolio manager at Mellon Capital Management in San Francisco. Xiong is part of a team that oversees $18 billion in assets.

CLASSIC DEBT TRAP

The Obama administration expects a deficit for the fiscal year ending September 30 of 10.6 percent of gross domestic product, the highest since World War Two. It says deficits will fall to 3.9 percent by 2014, still above the 3 percent level economists consider sustainable.

Even if all goes to plan, the White House expects U.S. public debt to rise above 71 percent of GDP by 2013 from 53 percent in 2009. The increase could spook investors and drive up government borrowing costs.

The negative implications for the dollar, RBS’ Ruskin said, “probably pivot” where higher yields are seen as clearly detrimental to growth and undermining future fiscal projections in what he called “a classic debt trap.”

Some analysts believe a rise above 4.5 percent in U.S. 10-year yields may have investors worried about its impact on mortgage rates and the housing market.

Morgan Stanley expects 10-year Treasury yields to rise to 5.500 percent by the end of the year. The latest Reuters poll showed the median forecasts for 10-year U.S. bond yields at 4.23 percent in 12 months.

Boris Schlossberg, director of currency research at GFT in New York, said the nonfarm payrolls report due on Friday will provide key clues as to whether the recent rise in U.S. rates is benign or toxic.

A report on Wednesday showing U.S. private employers unexpectedly shed jobs in March raised speculation Friday’s data may come in lower than expected.

If “the employment data is weak then the deadly mix of weak economic growth and steadily rising rates could raise concerns of a brewing sovereign debt crisis on this side of pond,” Schlossberg said. Of course, this could cause yields to fall, thus lowering borrowing costs.

Other currencies have reckoned with the debilitating effect of higher yields. In recent months, fiscal worries about public finances in peripheral euro zone economies such as Greece have hit the euro hard. The single currency has declined more than 5 percent versus the dollar so far this year.

Greg Salvaggio, senior vice president for capital markets at Tempus Consulting in Washington, said the less-than-robust subscription for U.S. bonds last week highlighted the importance for Washington to support a strong dollar policy. The Treasury will sell more debt this coming week.

“We think this is going to emerge as an important dollar story this year,” he said. “Given the ever waning demand for current bond auctions, it’s going to become critically important for Treasury to assure markets that the dollar value of their holdings will be maintained.”

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(Editing by Andrew Hay)

Rising yields could turn toxic for U.S. dollar