February 19, 2008 / 8:55 PM / 10 years ago

Steeper U.S. yield curve may help dollar vs euro

NEW YORK (Reuters) - The U.S. dollar could get some relief versus the euro and Swiss franc in the months ahead as European banks, with balance sheets besieged by the credit crisis, take advantage of a steeper Treasury yield curve to improve earnings and rebuild their balance sheets.

U.S. and European banks are scrambling to replenish damaged capital bases after writing down billions of dollars worth of assets related to investments in the risky U.S. subprime mortgage sector.

Swiss bank UBS UBSN.VX has been the hardest hit, with writedowns of about $18 billion so far, and more expected, prompting it to make plans for raising at least $11.8 billion in new funds.

“The Fed has forced the short-term interest rates down and the long-term rates have not really come down that much, so they (banks) get to earn a bigger spread between the money they take in and what they invest in,” said Jeffrey Saut, chief investment strategist at Raymond James & Associates in St Petersburg, Florida.

A cut in the federal funds rate of 2.25 percentage points since September last year by the Federal Reserve has pushed down short term U.S. yields and left longer term yields sharply higher.

This has allowed banks to cash in on the widening spread between rates of varying maturities by borrowing cheaply in the short-term and lending at a premium over longer periods.

The spread between the 2-year and 10-year U.S. Treasury notes is about 186 basis points wider, versus 97 basis points at the end of 2007. The euro zone yield curve is about 82 basis points steeper, compared to 34 points at end of last year.

Last week, the Treasury yield curve assumed its steepest slope since July 2004, according to Reuters data.


European banks may be tempted to take advantage of the yield carry in U.S. dollars.

The trade is reminiscent of the Japanese experience in the 1990s when banks there with bad balance sheets used a steep domestic yield curve to improve earnings and shore up their balance sheets, resulting in the yen’s strong performance. This time, though, it will be the U.S. dollar that benefits.

“One could argue that it’s not just U.S. banks that will take advantage of a steep U.S. yield curve. European banks would probably want to manage their cash balances the same way the U.S. banks would and buy relatively risk free instruments like Treasuries,” said David Gilmore, partner at FX Analytics in Connecticut.

“That process would tend to keep more balances, at least on the banking side, in U.S. dollars. A steeper curve is arguably helpful for the U.S. dollar in the period ahead, probably does more help versus the European currencies and less against the yen,” he said.

The euro appreciated 10 percent against the U.S. dollar in 2007 and is about 1.0 percent higher so far this year.

“With banks under pressure to recapitalize you’re going to see far more cash balances left in dollars to take advantage of the steep yield curve and that would be dollar supportive,” said Gilmore.

“I am not sure that speculators would be eager to buy dollars just because we have a steep curve. I would be more inclined to view it as a reason to expect the dollar not to continue to weaken (against the euro).”

With the European Central Bank perceived to be behind the curve in its monetary policy easing, analysts reckon that could hurt the euro’s prospects against the dollar.

Many argue that the Fed’s aggressive interest rate cuts and the government’s fiscal stimulus package have given the U.S. economy a better chance of emerging quickly from the subprime mortgage crisis, while euro zone still had to feel the pain.

“The ECB is in a state of denial, but there is a feeling it will have no choice but to cut interest rates,” said David Detze, chief investment strategist at Point View Financial Services in Summit, New Jersey.

“The dollar will strengthen because as the value of the curve steepens it reflects an economy that is starting to get back on its feet, while the European economy grapples with the fallout from the subprime crisis.”

Currency strategists at BNP Paribas expect the U.S. dollar to perform strongly against the Swiss franc, citing huge subprime mortgage related losses reported by UBS and the fact that the yield curve in that country is showing its deepest inversion since the 2001.

This suggests that Swiss banks cannot use the country’s domestic capital market for generating riskless carry income, they say.

But with the yield curve steepening sharply, currency hedging for Japanese investors has become cheaper, a factor that may drag the U.S. dollar lower against the yen, analysts said.

Japan is the largest holder of U.S. Treasuries. While Japanese investors continue to seek long-dated U.S. paper, this would not support the U.S. dollar because they were simultaneously reducing their currency hedges, analysts said.

“The steeper yield curve means that a Japanese based investor is likely to consider to hedge a bond portfolio he is holding in the United States,” said Hans Redeker, BNP Paribas’ global FX strategy head.

“In respect of fresh flows, it would be currency neutral, but in respect of existing positions it would actually mean that Japanese investors would need to sell dollars for hedging purposes.”

This was so because the U.S. yield curve was steepening in an environment of increasing risk aversion, Redeker said.

Editing by Clive McKeef

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