We doubt short-term yield gaps will weigh on the US dollar
My subscription
My Subscription All Publications

We doubt short-term yield gaps will weigh on the US dollar

Even if short-term nominal yield gaps continue to shift against the US dollar, we don’t expect its rally to abate yet.
  • In the UK, we suspect retail sales volumes declined for the fifth time in six months in July …
  • … and the fiscal position was probably a bit worse than the OBR’s forecast (07.00 BST)
  • Clients can catch-up on our Drop-In on Europe and the impact of Russia’s gas threat here

Key Market Themes

Even if short-term nominal yield gaps continue to shift against the US dollar, we don’t expect its rally to abate yet.

Earlier today, Norges Bank continued its tightening cycle against a backdrop of elevated domestic inflationary pressures. The hawkish tone of its policy statement has led us to raise our forecasts for the central bank’s policy rate in the coming months. Market participants seem to have reached a similar conclusion, and short-term government bond yields in Norway have risen. Similarly, short-term yields edged up earlier this week in the UK after the release of July CPI data and in New Zealand following the latest rate hike by its central bank.

By contrast, short-term yields in the US have edged a bit lower this week, probably due in part to the Fed’s acknowledging the risk of excessive tightening in the minutes of the FOMC’s 26th-27th July meeting. But while this means that short-term yield gaps – for example, the 1-year government bond yield gap – have shifted against the US dollar, other G10 currencies have actually fallen against the greenback this week. (See Chart 1.)

Chart 1: Changes Vs USD & Changes In Relative 1-Year Government Bond Yield Spreads Since 12th Aug. 2022

Sources: Refinitiv, Capital Economics

We think two main factors explain the dollar’s strength despite unfavourable shifts in relative nominal interest rates.

First, despite the relative movement in nominal interest rates, real interest rates in the US have held up better than in many other economies over this time. We expect this to continue to be the case, as the US economy seems to be better placed to weather the effects of monetary tightening than its developed market peers. European economies have been heavily affected by the energy crisis, and those in Canada, Australia and New Zealand have highly leveraged and interest-rate sensitive housing sectors, meaning additional rate hikes there will probably weigh heavily on economic recoveries.

As such, while we think that the Fed is unlikely to reverse its rate cuts next year by as much as investors currently anticipate even as inflation falls sharply, we think central banks elsewhere generally will need to cut rates at least as quickly as seems to be discounted in markets. That’s likely to keep longer-term real yields in the US elevated relative to other G10 economies and underpin further strength in the dollar. (See Chart 2.)

Chart 2: DXY Index & 10-Year TIPS Yield (%)

Sources: Refinitiv, Capital Economics

Second, the US dollar has probably benefited from “safe-haven” demand following the release of weak activity data out of China earlier this week. If, as we expect, the global economy continues to sputter the dollar is likely to benefit further, especially against the more cyclically sensitive G10 currencies. (Jonathan Petersen)

Selected Data & Events




CE Forecast*

Fri 19th


Foreign Exchange Net Settlement and Receipts (Jul.)






Retail Sales Inc. Fuel (Jul)






PSNB Ex Banking Groups (Jul)





*m/m(y/y) unless otherwise stated; p = provisional

Key Data & Events


The minutes from the Fed’s July meeting provided relatively little to sway the balance one way or another in terms of the near-term policy outlook. Although officials now appear to be more concerned about the potential negative impact on the economy from higher rates, and of the risk that they tighten policy too much, that is still being set against concerns that high inflation could become entrenched if the Fed fails to bring it down. With the strong activity data and softer inflation figures released since the July meeting probably easing both of those concerns, on balance we still expect a 50bp hike at the Fed’s September meeting, and for rates to be raised to nearly 4% early next year. (Andrew Hunter)


Final euro-zone inflation data for July underline that price pressures remain strong. Both headline and core inflation were unchanged from the flash estimates of 8.9% and 4.0%, respectively, published two weeks ago. The detailed breakdown showed that the acceleration has been broad-based across goods and services, as well as between imported and domestically-produced items. With wholesale natural gas and electricity prices having surged again in the weeks since July, retail gas and electricity prices are set to rise steeply in the coming months, keeping the headline rate high. Meanwhile, Norges Bank raised its policy rate by 50bp, to 1.75%, and its updated guidance implied that further hikes, most likely of 50bp at a time, would follow at forthcoming meetings.

In the UK, we expect data released on Friday to show that retail sales volumes fell by 0.8% m/m in July. That would be the fifth decline in six months and would add to concerns that the economy will slip into recession in Q3. Meanwhile, we expect July’s public finances figures released tomorrow to provide more evidence that the government’s fiscal position is worse than the Office for Budget Responsibility (OBR) predicted back in March. We suspect total borrowing was closer to £4.5bn than the £0.2bn OBR forecast. (Jack Allen-Reynolds & Nicholas Farr)

Other Developed Markets

Australia’s employment surprisingly fell in July. Leaving aside the 2020 lockdowns, full-time employment fell the most since the 1991/92 recession. However, the unemployment rate fell to yet another record low and with job vacancies at record highs and employment surveys strong, we aren’t convinced that the labour market has turned just yet. (Marcel Thieliant)

Other Emerging Markets

The central bank in the Philippines raised its policy rate by a further 50bps to 3.75%, and gave a strong indication that more rate hikes are likely over the coming months. That said, with inflation set to peak soon and headwinds to the economic recovery mounting, we don't think the tightening cycle will run much beyond the second half of this year.

Turkey’s central bank unexpectedly cut its one-week repo rate by 100bp today, to 13.00%, despite the backdrop of inflation at almost 80% and an extremely poor external position. We wouldn’t be surprised to see further rate cuts this year towards 10%, which will increase the risk of another currency crisis.

And GDP data from Chile showed that the economy merely stagnated in Q2 and the chances are high that it will fall into recession over the second half of the year. Meanwhile, current account risks are continuing to build – with the deficit widening to more than 8% of GDP in Q2 – which will keep the peso on the backfoot. (Gareth Leather, Jason Tuvey, Kim Sperrfechter)

Published at 16.45 BST 18th August 2022.

Editor: John Higgins, john.higgins@capitaleconomics.com
Enquiries: Harry Chambers, harry.chambers@capitaleconomics.com

Jonathan Petersen Markets Economist
Continue reading

More from Capital Daily

Capital Daily

Pound likely to remain under pressure this year

We think the Bank of England will hike interest rates by less than money markets now discount, which in turn should keep the pound under pressure against the dollar.

17 August 2022

Capital Daily

Equity and commodity prices may go their own ways

We think equity and commodity prices will generally head in opposite directions over this year and next.

16 August 2022

Capital Daily

China’s equities and the renminbi may remain under pressure

We expect external and domestic headwinds to keep Chinese equities and the renminbi under pressure over the rest of 2022.

15 August 2022

More from Jonathan Petersen

FX Markets Update

We doubt the Canadian dollar’s resilience will last much longer

The Canadian dollar has held up relatively well against the US dollar so far in 2022, but we think the factors underpinning the loonie’s resilience will fade and push it lower against the greenback over the next couple of years. In view of the wider interest, we are also sending this FX Markets Update to clients of our Canada Service. 

11 August 2022

FX Markets Weekly Wrap

Dollar rallies as hope for a Fed pivot proves short-lived

The huge upside surprise in US payrolls data pushed the greenback higher against most major currencies today in an otherwise quiet week for FX markets. The continued strength of the labour market in the US adds to our conviction that the Fed remains some way off from taking its foot off the brakes, a message echoed by several Fed officials earlier in the week. By contrast, many other central banks face more difficult trade-offs: the latest labour market data from New Zealand and Canada showed falls in employment; the BoE and RBA both hiked by 50bp but revised their forecasts to reflect higher inflation and lower growth; and some emerging market central banks appear to be at or near the end of their tightening cycles. Next week’s US CPI data, which we expect will show continued strong core price pressures even if headline inflation slows, could put another nail in the coffin of the ‘pivot’ narrative. Even in the absence of further divergence in monetary policy, we expect slowing global activity and worsening risk sentiment to, underpin further strength in the greenback over the rest of the year.

5 August 2022

Capital Daily

We expect real yields to be a near-term headwind for gold

We think that real yields in the US will continue to rise and put renewed pressure on the price of gold and most other assets.

3 August 2022
↑ Back to top