US Dollar Interest Rate Bias: Bullish

US interest rates and rate expectations fell sharply from mid-2007 through early 2008, but the term structure on the US dollar yield curve clearly shows markets expect much more through the coming two years of trade. We measure medium term interest rate forecasts as the difference between short-term (3-month) interest rates and their longer-term counterparts (2 years).

The yield spread chart above clearly shows that rates and rate expectations fell sharply through the beginning of the year, but the spread between 2-year and 3-month rates has since turned positive and 2-year swap rates trade above 3.0 percent. This signals that traders believe interest rates will effectively only go up from current lows, and expectations for improvements in the US dollar’s stance against major forex counterparts has easily boosted sentiment on the downtrodden greenback.

One caveat of course is the fact that the 3M-2Y yield spread has shrunken significantly from its 120 basis point highs seen in June. A relatively steady stream of bearish US economic data suggests that interest rates may not climb nearly as quickly as markets had initially expected. Such a development is inarguably bearish for US interest rates, but as forex traders we know that forex rates will vary according to the differences between currencies. That is to say, a similarly bearish outlook for global interest rates means that the US dollar may nonetheless continue to gain on a clear deterioration in forecasts for the euro, British Pound, and other key counterparts.