Despite conflict in the Middle East and risks of trade wars, yields of US Treasuries have risen while the US dollar has depreciated. Both bonds and the currency normally benefit from investor demand in troubled times. Does this yield/dollar conundrum mean US assets are losing their safe-haven status? Perhaps, but there is more to it than meets the eye.
Listen to the article
US Treasury yields usually tend to move in unison with the dollar: strong US growth tends to lift valuations of both assets, and vice versa. Put another way, higher US bond yields attract capital, which strengthens the dollar. However, this correlation broke down early this year (see Exhibit 1).
The yield/dollar puzzle
Since financial markets are not pricing in any major disruptions of oil supply or a protracted Middle East conflict, there have been few safe-haven flows into dollar assets. It is also possible that, if an oil price spike were sustained and pushed up inflation, it would boost bond yields. Indeed, US yields have crept higher and remained range bound since January as rising geopolitical turmoil threatens to boost oil prices and inflation.
Treasury yields may now be kept high by the US Federal Reserve’s reluctance to cut interest rates.
Meanwhile, the dollar is reacting to expectations of
- A weaker US economy relative to other major economies, notably Europe
- A divergence between the Fed and other major central banks, notably the Bank of Japan which has been raising interest rates to normalise its ultra-low monetary policy.
Finally, the high-yield/low dollar conundrum may reflect investor concerns over the surge in the US fiscal deficit and national debt should President Donald Trump’s ‘One Big Beautiful Bill’ be enacted.
We argue that the decoupling between Treasury yields and dollar movements appears to reflect the cross-currents behind the growth-inflation dynamics that have left the Fed between a rock and a hard place, resulting in policy inaction and financial market volatility.
Rate cuts – When the time is right
Nevertheless, we believe interest rate cuts remain on the cards. The question is the timing. Fed Chair Jerome Powell delivered his semi-annual report to Congress on 25 June and reiterated monetary policy was well positioned and that the Fed will wait and see before making any adjustments – despite remarks from policymakers Bowman and Waller about a possible rate cut in July.
While the level of the ‘reciprocal’ tariffs from ‘Liberation Day’ on 2 April seems to have been watered down, it is still unclear what the final levies will be as trade negotiations continue with various countries.
Hindsight of the 2018-19 Sino-US trade spat shows that import tariffs would push up inflation about three months after implementation.
For now, the outlook for growth and inflation remains cloudy for the Fed. As to the Fed’s dual mandate of full employment and stable prices, the risk now appears to be that the US labour market could fall short of the Fed’s objective, in which case inflation will likely ease even in the face of Trump’s tariffs.
Labour market softening has been evident from the steady decline in the ratio of job vacancy-to-unemployed since the peak in 2023, and the slowdown in labour cost growth (see Exhibit 2).
Although non-farm payrolls grew by more than expected at 139,000 in May, the numbers for the preceding two months were revised down by a sharp 95,000, leaving a net gain of just 44,000 new jobs.
For context, we note the one-time effect of (higher) tariffs on prices will drop out of the data after one year. To generate sustainably higher inflation, tariffs would have to rise every year and become embedded in long-term inflation expectations.
However, there has been no indication that President Trump will keep raising tariffs and, given the softening of the labour market, long-term inflation expectations have been falling this year (see Exhibit 3).
Trade war – Truce is not a game changer
While the US and China in June agreed on a trade negotiation framework, it is unlikely to change the prospects of weak US growth and higher inflation into 2026. The accord appears more of a tactical measure to de-escalate tensions than a long-term resolution of deep distrust between the two countries.
The relatively weaker outlook for US growth will likely keep downward pressure on the US dollar and Treasury bond yields until the outlook changes. Tariffs are also creating greater uncertainty over the path of inflation. They will cause the yield curve to steepen: the long end is likely to reflect a premium for tariff uncertainty and worries over years of larger fiscal deficits should the ‘One Big Beautiful Bill’ become law.
