The 'Safe Haven' U.S. Dollar: Keeping Rates Low With Fleeing International Money

John Mason discusses how a flight to safety keeps long-term US rates relatively low and how this affects TIPs

The 'Safe Haven' U.S. Dollar: Keeping US Interest Low With Fleeing International Monies

Summary

  • Things are not going well for Turkey and this fact is being reflected in international currency markets and in "safe haven" bond yields.
  • Once again, the flow of  "risk averse" funds into the United States is not only strengthening the value of the dollar but it is lowering longer-term interest rates.
  • This is a very clear example of how these international flows have kept US interest rates so low for the past seven to eight years.

The value of the US dollar rose to highs not seen in over a year.

The US dollar index (DXY) rose to 96.34 today. It was around June 22 2017 that this index was last this high.

It only took $1.1410 to purchase one Euro today and only $1.2774 to buy one British pound.

The reason for these moves has been the crisis in Turkey. This crisis has resulted in funds leaving Turkey…Europe… and the United Kingdom. Making the situation worse… for Turkey… has been the efforts of President Trump to come down hard on Turkey’s President Recep Tayyip Erdogan.

Relations between the US and Turkey have not been good, but over the past two weeks they have plummeted.

A lot of this “risk averse” money is moving into the “safe haven” of US Treasury securities. The yield on the 10-year US Treasury note dropped to 2.87 percent on Friday, down from 2.93 percent at the close of the market on Thursday, 2.97 percent at the close on Wednesday, and 3.00 percent at the close of business on Wednesday August 1.

Even more interesting is the fact that the yield on the 10-year US Treasury Inflation Protected securities (OTC:TIPS), has declined in parallel with the decline in the nominal bond yield.

On August 1, the yield on the 10-year TIPs was 0.85 percent; on Wednesday, August 8, the yield on the TIPs was 0.83 percent on Thursday the yield dropped to 0.81; and on Friday, the yield dropped to 0.75.

There was a 13 basis point drop in the nominal yield and a 10 basis point drop in the TIPs yield.

Conceptually, one can divide the nominal bond yield into two components, the expected real rate of return on the bonds and the expected rate of inflation. A proxy for the expected real rate of return is the yield on the 10-year TIPs. The expected inflation rate is the difference between the nominal yield on the 10-year note and the yield on the 10-year TIPs.

The expected rate of inflation built into the nominal yield on the 10-year Treasury is right around 2.13 percent, the level it has been at for several months now.

This means that the decline in the nominal rate of interest has come from a decline in the expected real rate of return.

On August 1, 2018, the yield on the 10-year TIPs was around 0.85 percent or 85 basis points.

Theoretically, the expected real rate of interest is expected to be somewhere around the expected rate of growth of the economy.

What might be the expected rate of growth in the US economy right now?

Well, the compound rate of real economic growth of the US economy has been 2.2 percent over the past nine-year period.

If we use this 2.2 percent rate as the expected rate of growth for the future, we see that the expected real rate of interest, 85 basis points, is substantially below the expected rate of growth of the economy.

Why might this be the case?

Over the past six or seven years I have argued that the yield on the TIPs, the expected real rate of return has been substantially below the expected growth rate of the economy because of all the “risk averse” monies that have been flowing into the United States seeking a “safe haven.”

One can closely relate these flows of funds with movements in the yield on the TIPs, but can also directly tie them to the times when the yields on the 5-year and 10-year TIPs went into negative territory.

The yield on the 5-year TIPs really dropped in the third and fourth quarters of 2010 and dropped into negative territory during that time period. The yield on the 10-year TIPs also declined, but did not go below zero percent until the last half of 2011.

And, these two yields have remained low, moved as the “risk averse” monies flowed into and out of the United States as the financial dislocations in other parts of the seemed to heal…or to get worse. Over the past year and one-half, as things appeared to settle down in international financial markets the yields on the TIPs securities rose. However, the high for the 10-year TIPs was never much above 0.90 percent…or, 90 basis points.

Consequently, I have been arguing over the past several years that the real reason for the low, longer-term rates of interest has been the fact that there still were enough “risk averse” monies in the United States to keep the longer-term rates as low as they were.

Note that the bond yields also fell in other "safe havens" like Germany and Switzerland.

I have recently written about the current level of interest rates and the possibility that the longer-term yields might go higher. The story is all about the risk component of the expected real rate of return on the bonds and the expected rate of inflation.

Now, however, I have an explicit example of how the international “risk averse” funds are impacting bond yields. The timing could not be more closely connected with the movement of currency rates and the bond yields.

The money is rushing into the United States, so that the value of the US dollar gets stronger, and when it gets to the US, the money, in large part, is going into US Treasury securities.

And, we see that the nominal yield on the 10-year Treasury note is in decline once more.

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