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What are the implications for the U.S. dollar of lower real rates?

Ron Leven
Ron Leven
Professor of Economics at Duke University

Following the recent increase in U.S. inflation, and the consequent inaction of the Federal Reserve, what will be the impact on the U.S. dollar? 


  1. In the U.S., falling unemployment and rising commodity prices are the recipe for an increase in inflation, and the level is currently above the Fed’s target.
  2. This combination of factors implies a drop in real short-term interest rates.
  3. Unless the Fed hikes rates sooner and more aggressively than suggested in the recent Open Market Committee meeting, the dollar is vulnerable to substantial weakness.

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May’s Market Voice highlighted that both the pace of job growth and the level of unemployment are on the tipping point of levels that historically are associated with rising inflation. The drop in May’s unemployment rate to 5.8 percent is now pushing the picture beyond the tipping point, making the prospects for inflation yet more likely.

In the meantime, as shown in Figure 1, unprecedented gains in commodity prices make it almost certain that general price indices like the CPI will, at least temporarily, be pushed significantly higher.

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Indeed, CPI inflation is already breaking above 4 percent for the first time since the financial crisis. There is also evidence that the market is pricing in a less benign inflation for the coming years.

U.S.inflation is above the Fed’s target level

Figure 1 also shows the level of inflation implied by the inflation-adjusted ‘TIPS’ Treasury notes. The “breakeven” inflation rate is the level needed to equalise the return on a TIPS bond and the same maturity traditional Treasury note.

Both 2-year and 5-year breakeven inflation have moved higher since the end of last year. While the 5-year breakeven has moderated, at 2.5 percent it is still significantly above the Fed’s 2 percent target level.

Figure 1: CPI YOY inflation and TIPS-based forward implied inflation

Month-End Data – YoY changes

Figure 1: CPI YOY inflation and TIPS-based forward implied inflation. What are the implications for the dollar of lower real U.S. rates?
Source: Eikon – Click on chart to request a free trial

The Fed took a baby step in the direction of tightening at this month’s Open Market meeting. While it still believes the CPI gains are temporary, it is now considering ways to draw back on quantitative easing – e.g., by reducing its bond buying programme.

Nevertheless, the target to achieve an average rate of inflation of 2 percent implies that past years of below target inflation creates room for some years of above target inflation.

It seems that despite inflation being already well above the Fed’s target of 2 percent, there is little chance of a near-term hike in the Fed funds rate.

Rate hikes and the futures market

While stock and commodity prices have reacted negatively to the Fed comments, as shown in Figure 2, the futures market is not pricing in any rate hike by the end of this year and only one 25 basis point hike by the end of next year.

Figure 2: Futures-market implied Fed Funds Rate

Figure 2: Futures-Market implied Fed Funds Rate. What are the implications for the dollar of lower real U.S. rates?
Source: Eikon – Click on chart to request a free trial

Real short-term interest rates and the U.S. dollar

The combination of rising inflation and a Fed on hold until at least late next year tautologically implies a drop in real short-term interest rates.

Figure 3 indicates this is potentially very bad news for broad U.S dollar performance.

The JPM nominal index for the broad U.S dollar has strengthened substantially over the past decade. For roughly the five years from 2011 to 2016, the U.S dollar’s strength was supported by rising nominal and real interest rates.

The ‘real’ rate shown in the chart is the 1-year Treasury rate less the prior year CPI inflation and the U.S dollar, and over the long-term the dollar has a much stronger link to this real yield than to the nominal 1-year Treasury rate.

The U.S dollar’s strength appears overdone, even when rates were peaking two years ago, and with the real rate now plunging to multi-decade lows the dollar looks apt to be heading to weaker territory over the year ahead.

Figure 3: USD broad nominal (trade-weighted) index and nominal and real 1Y- U.S. Treasury Rate

Figure 3: USD broad nominal (Trade-Weighted) index and nominal and real 1Y U.S. Treasury Rate. What are the implications for the dollar of lower real U.S. rates?
Source: Eikon – Click on chart to request a free trial

The priced in outlook for real rates is also pointing to a much weaker U.S dollar.

The forward implied real interest rates was calculated by deducing the 1-year nominal interest rate two-years forward that is embedded in the Treasury yield curve.

Similarly, the 1-year inflation rate two years from now is deduced from the two- and three-year TIPS breakeven inflation rates. The difference in the two is the derived 1-year interest rate implied two years from now.

History suggests that this forward-looking indicator of expected real rates leads the U.S dollar by roughly one year. Higher inflation seems to be baked into the cake, so unless the Fed rapidly changes course on monetary policy, it looks like the USD is headed significantly lower.

Figure 4: Market implied future real interest rates and the USD broad nominal index

Figure 4: Market implied future real interest rates and the USD broad nominal index
Source: Eikon and the Federal Reserve Bank of St Louis. Click on chart to request a free trial of Eikon

The down low on G10 implied FX volatility

Figure 5, extracted from the Eikon Currency Value Tracker, indicates that 3M implied volatility for the USD vs other G10 currencies are almost all below the 3-year average, and for several are downright cheap.

NOK is slightly above the three-year average but JPY and SEK are in the bottom 15th percentile. GBP implied volatility is nearing historical lows as it is in the bottom 5th percentile.

Figure 5: USD vs G10 currencies implied volatility

USD vs G10 Currencies Implied Vol
Blue denotes in 3Yr 5th percentile and dark blue denotes in the 3Y 15th percentile. Source: Eikon. Click on chart to request a free trial

Not surprisingly, as shown in Figure 6, NOK implied volatility is heavily reflective of activity in the crude oil market.

In particular, the surge in crude oil volatility in the onset of the pandemic led to a spike in realised NOK volatility to levels not seen since the financial crisis and similar but more prolonged move higher in implied NOK volatility.

Oil volatility has moved back into the pre-pandemic range; while NOK implied and realised volatility has moderated and because it is no longer historically high has room to move lower if, like oil volatility, it moves back to pre-pandemic levels.

Figure 6: NOK implied and realised 3M volatility and crude oil 3M realised volatility

NOK implied and realised 3M Volatility and crude oil 3M realised volatility
Source: Eikon – Click on chart to request a free trial

GBP implied volatility, as shown below, is heading towards all-time lows.

While realised volatility is also heading sharply lower, as shown in Figure 5, implied volatility is also well below norm – in the 22nd percentile – versus realised volatility.

Both implied and, especially, realised GBP volatility have generally tracked the UK stock market with a bull trend in the stock market associated with declining GBP volatility. But in contrast with NOK volatility, which is lagging the normalisation of oil prices, the GBP volatility decline is well ahead of the recovery in stock market prices.

With GBP implied 3M implied volatility near all-time lows and cheap relative to realised volatility, going long implied volatility would seem to be an attractive hedge against a potential reversal in equities.

Figure 7: GBP 3M implied and realised volatility and UK FTSE Stock Index

GBP 3M implied and realised volatility and UK FTSE Stock Index
Source: Eikon – Click on chart to request a free trial

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