Traders Grapple With World That’s Good for Dollar, Bad for Bonds

k)8imp0u04s60p27sjjurrc2_media_dl_3.png Bloomberg

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(Bloomberg) — What’s good for the US dollar isn’t always good for US bonds — but investors are finding ways to work around it.

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Even as the greenback draws support from a resilient American economy and renewed tensions in the Middle East, those same variables have pressured US Treasuries. Bond yields have remained elevated on concerns that strong growth and higher oil prices will stoke already-sticky inflation and prompt Federal Reserve interest-rate hikes.

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The outlook is most clearly reflected in a sharp rise in so-called real US yields, which strip out the effect of inflation on returns. The yield on inflation-adjusted, 10-year Treasuries last week climbed above 2.3%, its highest level in more than a year, as investors price in tighter Fed policy in the months ahead. 

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“The reason real yields are where they are today is straightforward,” said Brendan Murphy, head of fixed income for North America at Insight Investment, which manages about $836 billion in assets globally. “The Fed has turned more hawkish, economic data has remained resilient and inflation has stayed elevated.”

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For investors, this creates a conundrum. While the rise in real yields relative to those in other major markets makes dollar-denominated assets more attractive to global investors, investing in inflation-sensitive US bonds leaves investors vulnerable to losses. Some, however, are finding ways to thread the needle.

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Adam Coons, chief investment officer at Winthrop Capital Management, which manages more than $3.9 billion, says he is long the dollar, but less positive on longer-term US bonds that will get hit the most should the US economy continue to outperform the rest of the world and fuel inflation. He’s funding the firm’s long dollar exposures by selling the euro and yen, currencies that offer less attractive all-in yields.

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“The dollar is currently enjoying the best of both worlds. It offers high yield and superior economic growth,” Coons said. He’s wagering that longer-term bonds in the UK and Europe will perform better than their US counterparts.

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The greenback has historically tracked US real yields closely. That relationship fractured last year as the Trump administration’s trade war shook confidence in US assets, but it has since re-emerged, putting the Fed’s rate outlook — especially relative to major peers — back at the center of the dollar’s trajectory.

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The Bloomberg Dollar Spot Index held firm last week, not far from its highs for the year, as fresh doubts emerged around peace prospects between the US and Iran. The yield on policy-sensitive two-year Treasury notes rose 7 basis points to 4.21% — also near its year-to-date high. Over the weekend, the US and Iran traded strikes, while Washington and Tehran issued conflicting declarations over whether the Strait of Hormuz remains open to shipping.

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At Brandywine Global Investment Management, portfolio manager Jack McIntyre argues the dollar’s recent strength is justified as markets price in a more hawkish Fed and holds an underweight position in Treasuries, in large part because of the robust US economy.