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Link Between Treasury Yields
and Dollar Is Questioned

By Steve Johnson
Financial Times, London
Wednesday, March 23, 2005

Two leading investment banks on Wednesday questioned whether rising US Treasury yields would increase the attractiveness of the dollar, even as the US currency rose on the back of rising US inflation
concerns.

"We question how much support the dollar will get from rising US interest rates at this point," said Marvin Barth, currency economist
at Citigroup.

"Higher short-term interest rates could merely cut into expected returns on US assets, denting their attractiveness to investors."

Tony Norfield, global head of forex strategy at ABN Amro, said: "We question the simplistic view that just because Fed funds are going up more than rates in other countries, that will give the dollar
support. The kneejerk reaction has been to buy the dollar, but the medium-term impact could yet be negative."

The US dollar rose after the higher-than-expected inflation data and the afterglow from Tuesday's Federal Reserve meeting, which buoyed expectations of more rapid US interest rate rises to come.
This double salvo sent the yield on 10-year US Treasuries up to 4.64 percent, a far cry from their 3.98 percent nadir in mid-February.
In response the dollar hit one-month highs against the euro, yen, sterling, Swiss franc, and Australian dollar as the continued liquidation of dollar-funded carry trades aided the greenback.

The conventional wisdom is that further rises in Treasury yields, fuelled by higher rates at the short end of the curve, will boost the attractiveness of US debt, bolstering the dollar.

But ABN cites the example of 1994, when US yields rose by 2.5 percentage points but the trade-weighted dollar fell by 15 percent.

Mr Norfield fears higher US Treasury yields could slow consumer spending by pushing up mortgage and credit rates. This in turn could cause problems for US equity markets.

And while rising Treasury yields may encourage the likes of overseas life insurers to add to their holdings, the resultant capital losses may encourage other investors to cut their positions.

The 1994 selloff was partly due to poor signposting of future rate moves from the Fed, a mistake not being repeated this time.

But in some respects the background is less propitious than in 1994. Then the US current account deficit was 1 percent of GDP. Today it is 6.3 percent. Thus it is more critical than ever that foreign investors maintain their appetite for US assets in order to fund
this deficit. Arguably dollar assets should also carry a higher risk
premium.

"If asset prices fall as a result of an inflation scare, it is hard to see how the US current account deficit will be financed," said Mr Norfield.

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