What is the price of the euro-dollar pair right now? Is it overvalued or should you buy some on the spot? What about gold? Would its price increase soon? Add the above questions to the hundreds of questions finance professionals ask every day, and you still do not get a clear picture about trading in the financial markets. The thing is all the prices that are on your trading terminal are directly or indirectly affected by the yield of the U.S. debt.
The dollar being the reserve currency of the world affects all aspects of our daily lives; from buying a new car, to investing in a factory, and other minor and major investment decision, the dollar’s price is an important tool to value all commodities and trade transactions in the world. This price depends on multiple factors such as the demand on the dollar for domestic and international trade, and the health of the US economy, which affects the Federal Reserve’s monetary policy stance and decisions to achieve its dual mandate of price stability and employment maximization.
One of the Feds’ powerful monetary policy tool is changing the Federal Funds rate, defined as the interest rate depository intuitions lend reserve balances to other depository institutions overnight, on an uncollateralized basis. This tool has significant effect on the yield of the U.S. debt/ treasuries with different maturities, also known as the return an investor realizes on the mentioned fixed income instruments. That yield aid investors to identify the minimum rate of return that they require on any investments excluding other risks associated with such endeavor such as liquidity risk, credit risk and maturity risk. It inversely changes with the price of the note/bond, which was dramatically affected by the QE program the Fed launched back in 2008 to prompt investment and consumption. This program was considered an unorthodox monetary tool as few central banks use it as a method to help ailing economies, and since 2014 the Federal Reserve have ended this program and now focuses on reducing the excessive money supply it has pumped during 2008, by sucking money from the financial system using the Federal Funds Rate, hence increasing the yield, thereby investors get attracted more to fixed income instruments. This increase in the Federal Funds Rate comes in line with an increase in the U.S. economic activity as the GDP recorded an increase of 4.1% in Q3 2017, the highest level reached since September 2015, and unemployment rate of 4.1%, the lowest level recorded since the 2008 crisis. Moreover, U.S. Purchase Managers Index, a leading economic activity indicator continue to show robustness in the past 12 months reaching 58.7. Also, US company’s earnings continue to improve year to year and beat expectations as 66% of corporations that reported its results in Q3 2017 have beat analysts’ expectations, and beat the prior quarter average of 50%. In addition, revenue growth shows an increase of 5% in Q3 2017 vs a 2.6% in Q3 2016. All mentioned data prove that the health of the US economy continues to improve, which will prompt companies to invest and hire more people thus increasing wage growth, inflation expectation, the Federal Funds Rate and the yield on U.S Treasuries, and lastly the price of the U.S. dollar.
This development is associated with significant risks. Starting with geopolitical risks, as tensions with North Korea rise, and recent developments In the Middle East show an escalation in geopolitical risks. Moreover, the price of equity and bond instruments continue to increase to sky-high territories as investors continue to spend cash on equities and buy them at a higher price. Unless earnings continue to grow higher than prices, equity markets stand as risk which investors should consider in the year to come. In addition, bond and retirement funds face major challenges to enhance the performance of the portfolios to achieve a higher rate of return to fulfill their future obligations toward retirees.
All in all, the Federal Reserve will continue on its path of normalization aided by an improving U.S. economy, which will increase the yield on the 10-year note. So, the next time you open your trading terminal make sure to search and check the yield and price of the 10 years note before initiating any trading activity as it plays a pivotal role in the day to day financial decisions.