Westpac explains why the US dollar is getting beaten up

Mark Kolbe/Getty Images

If it wasn’t clear already, it appears that inflationary pressures in the United States are now finally starting to build.

A sharp acceleration in wage growth in January, something that may or may not have been driven by inclement weather, was followed up by hotter-than-expected consumer and producer price inflation readings this week, sending benchmark 10-year US bond yields to fresh multi-year highs.

However, despite the prospect of firmer economic growth and stronger inflation in the US, something that suggests the US Federal Reserve may have to lift interest rates faster than currently anticipated, the US dollar hasn’t rallied alongside yields.

Quite the contrary, it’s taken a bath, currently teetering just above the previous multi-year low struck in January this year.

So what gives?

US inflation is picking up, as are bond yields. And Congress just passed a significant fiscal stimulus program at a time when the US economy is already strong, raising the risk that the Fed may have to hike fast and high in the years ahead.

But the dollar’s looking like a dog, at least based off the recent price action.

To Westpac Bank, rather than being a delight for the US dollar, the prospect of higher US government budget deficits has been a drag, pointing to the performance of the US dollar trade-weighted index against the US budget position as a percentage of GDP.

Source: Westpac Bank

“The breakdown in deeply entrenched fundamental linkages that hold near axiomatic status, namely the link between the USD and US yields, might not be the mystery many believe,” says Richard Franulovich, chief currency strategist at Westpac.

“Much of the rise in term premiums (yields in longer-dated US bonds) coincides with heightened deficit risks following the two-year $300 billion budget bill that puts the US deficit on course to hit 4.5-5.0% of GDP this year.”

Franulovich says that while US wage and inflation pressures might be stronger than elsewhere in the world, economic growth, confidence and employment across other G10 nations is largely the same.

As such, Franulovich says that the “US dollar outlook remains negative”.

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