Long Term Interest Rates And US Dollars

Following the direction of short-term interest rates is a vital part of determining the likely direction of a particular currency or currency pair. But what can long-term interest rates tell us about the future price behavior of currencies?

Rising long-term interest rates have been very much in the news lately. On June 13, the yield on the 10-year T-note climbed to a five-year high of 5.327 percent. The 4.50-percent note finished June at a yield of 5.03 percent — 54 basis points higher than its March 7 low of 4.49 percent. (For a review of T-notes and their terminology, see “Treasury backgrounder.”)

Normally, the yield curve — which depicts the difference between short-term and long-term Treasury yields — rises, reflecting the higher yields usually associated with longer Treasury maturities. When short- erm yields are higher than long-term yields, as has recently been the case, the curve is referred to as “inverted” — a condition that has historically been interpreted as a warning sign that a recession is looming. With the recent increase in long-term rates, however, the yield curve has returned to its normal shape.

What’s behind the jump in long-term interest rates? Supported by a strong May retail sales report (the best showing in more than a year), traders have become less convinced the Federal Reserve will cut short-term interest rates. At least one interpretation, then, of the rise in long-term rates is that it portends improvement in the prospects for economic growth.
Another interpretation is that improved economic growth could be accompanied by higher inflation. However, recent price data suggests inflation remains mild and appears to be under control. The personal consumption expenditures index (excluding food and energy), a key inflation measure, increased 1.9 percent in May vs. the same period last year. This is the smallest year-over-year increase since March 2004.