Market Musings 250125: What does a reversal lower in yields and the US dollar imply?

Market Musings 250125: What does a reversal lower in yields and the US dollar imply?

Since September 2024, when Donald Trump first moved ahead of Kamala Harris in the pre-election Presidential election polls, long-term US interest rates (in the form of the 10-year Treasury bond yield) have risen by over 1% from 3.6% to a peak of 4.8% by the beginning of this year. With this sharp move higher, financial markets seem to have priced the likelihood that:

1. Trump’s policies on tariffs and immigration will drive inflation higher over the medium-term, and

2. Potential further unfunded tax cuts for households and companies at a time when the US budget deficit is already at a very elevated 6% of GDP will mean more bond issuance, and greater risk to bondholders.

Strong US economy and post-election inflation concerns drove US long-term rates higher

One of the results of this move in the 10-year Treasury yield has been a sharp appreciation of the US dollar of about 10% on average against other major currencies such as the euro, pound sterling, Japanese yen and Chinese renminbi.

This represents the second major bull rally for the US dollar since the immediate aftermath of the 2020 COVID-19 pandemic crisis. Since the beginning of 2021, the US dollar index has risen cumulatively by 22%.

Since 2021, 2 big US dollar rallies

What if US bond yields and the US dollar reverse lower?

In the last week, we have seen a modest retracement lower from early January highs in both the US 10-year bond yield (4.6% now versus a 4.8% peak) and the DXY US dollar index (107.5 now versus 109.6 peak).

We can identify potential catalysts for these retracements to continue in both the bond yield and US dollar:

1. US inflation rates continue to moderate in the months ahead, helped by easing in energy (oil and gas) prices, lower wage growth and lower rental inflation. These are all easing trends that are underway.

2. Donald Trump does not enact tariff and immigration policies that are as immediately inflationary as the market has feared. We can still expect fresh tariffs to be levied on imports from Mexico, Canada and potentially China in the months ahead (with Trump mentioning new tariffs on Mexican and Canadian imports by February 1), but they may not be as wide-ranging or as elevated as initially expected.

3. Slowing US economic growth as the lagged effects of a stronger dollar start to drag on US exports.

Brent crude oil falls back on higher potential OPEC+ and US production

Beneficiaries from a lower USD

There are several effects of a weaker US dollar that are important for financial markets:

1. Greater overall global liquidity, which tends to be a positive for financial markets overall, stocks and commodities in particular.

2. Commodities in general, but particularly gold benefit from a weaker US dollar, given that this is the principal currency that they are priced and traded in.

3. Emerging market assets prefer a weaker US dollar over time.

Liquidity: US M2 money supply growth continues to rebound

I focus on the gold price for now, given that it has already broken new all-time highs in other currencies such as the euro, sterling and yen in recent days. Priced in US dollars, physical gold is a mere $20 away from its all-time high of $2790/oz hit in October.

Gold threatening to hit a fresh all-time high in USD, close to $2800/ounce

Have a great week

Edmund