Inspector Gregory: "Is there any point to which you would wish to draw my attention?"
Sherlock Holmes: "To the curious incident of the dog in the night-time."
Gregory: "The dog did nothing in the night-time."
Holmes: "That was the curious incident"
In Sir Arthur Conan Doyle’s “Silver Blaze,” the famous fictional detective Sherlock Holmes investigates the case of a missing race horse and the murder of its trainer. With his trademark insight and perspective, Holmes realizes that the horse’s guard dog did not wake up the owner, providing a strong clue; in his own words, Holmes explains, “I had grasped the significance of the silence of the dog, for one true inference invariably suggests others....Obviously the midnight visitor was someone whom the dog knew well.” In the end, the detective pins the caper on the trainer himself, who was killed when trying to injure the horse so that he could make money wagering against the stallion in upcoming races. The main thrust of the story is that the lack of a usual reaction (the dog barking) is often a valuable signal in and of itself.
I’m reminded of the curious incident of the dog in the night-time when looking at the relationship between the US dollar and US yields over the last couple of weeks. Contrary to the “usual” relationship, where rising 10-year treasury yields prompted traders to drive the US dollar up in tandem, the greenback has actually been falling sharply over the last three weeks, despite rising yields. Just like the dog’s failure to bark at the “intruder” provided valuable information, the breakdown of the positive relationship between US yields and the US dollar signals an important change in the “character” of the world’s reserve currency.
Throughout February and March, the US economy was seen as the “Best House in a Bad Global Economic Neighborhood,” so both the dollar and US treasury bonds attracted capital in tandem. Now that the extent of the Q1 slowdown in the economy is becoming clear though, traders are starting to doubt that the US can decouple from the slowing global economy, with negative implications for USD. At the same time, Fed officials seem hell-bent on raising interest rates in the September-December timeframe, despite their claims of being data-dependent, and traders are selling treasury bonds in anticipation of this seemingly-inevitable increase.
As a bit of background, it’s important to note that short-term correlation between the US dollar and 10-year bond yields is constantly fluctuating: they moved in tandem in October and November of last year, diverged sharply in December and January, resumed their positive relationship in February and March, and are now moving inversely once again. For the more quantitative readers, the 20-day rolling correlation between the dollar index and the 10-year bond yield (TNX) has fluctuated between 0.9 and -0.9, and is currently at -0.7 (see chart below)
So what’s the upshot of this divergence? In the near term, it suggests that traders are not focusing on yields as the primary driver of currency values. Instead, they are trying to “get in on the ground floor” on countries and currencies with improving economic fundamentals. Beyond the bearish dollar impact, this also suggests that currencies with relatively high yields but deteriorating economic performance, like the New Zealand dollar, could come under pressure in the coming days and weeks.
As always, it’s crucial for traders to monitor this key intermarket relationship and remain flexible in case the dog starts barking again.
Source: Stockcharts.com & FOREX.com. Note that this chart reflects yesterday’s prices; current levels as of writing are 94.17 for the dollar index and 2.24% in the 10-year bond.