US Dollar: Inflation expectations support USD and Treasuries – BNY

BNY’s Geoff Yu notes that U.S. long-term inflation expectations, measured via 5y5y swaps, are catching up with Europe’s as markets price prolonged disruption risks. He expects further convergence, with up to 10bp upside. Yu argues this should not undermine the Dollar, as higher real yields attract onshore and external investors back into U.S. Treasuries.

Higher real yields seen Dollar supportive

"Based on 5y5y inflation swaps, even after the first month of the conflict, U.S. long-term inflation expectations were around 15bp below levels seen at the beginning of the conflict, whereas U.K. and Eurozone equivalents had moved materially in the opposite direction, where they have remained even with the prospect of a permanent ceasefire. However, as U.S. data have begun to shift, the disinflation premia have swiftly eroded, and the 5y5y USD inflation swap is back to its levels at the beginning of the year and continues to rise."

"While there are crucial differences between the U.S. and European economies – being a net energy exporter and lower trade dependency to name a few – the experience of inflation expectations on the other side of the Atlantic justifies strong vigilance. We expect further convergence in inflation expectations through the second half of the year, which means further upside risk of up to 10bp should the change reach Eurozone levels."

"Despite the potential 25bp swing from end-March in the 5y5y, we don’t see such a move undermining the dollar, even if the Fed doesn’t react – nor should it, given its forecast horizon. For onshore investors, the moves in long-dated yields have been far larger than inflation expectations alone, which pushes up real rates across the curve and renders flows far more attractive to onshore bond investors."

"The U.S. has also benefited, to the extent that even external bond managers are re-entering the U.S. Treasury market, assuming that savings levels and trade surpluses begin picking up again while long-dated yields remain at a high level."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)