Why The Dollar Is Rising While Yields Are Falling, Blame It On The Taxman

“Read my lips, no new taxes” – These are words that President Joe Biden has never said in his 2020 campaign, but when he did run for the first time in the late 80s, the person that became the Commander-in-Chief uttered repeatedly. That president, George H. W. Bush, eventually broke his promise. And now in 2021, tax hikes are breaking something else – the correlation between Treasury yields and the US dollar.

GBP/USD is trading at the lowest in six weeks, EUR/USD is nearing the 2021 trough and commodity currencies are melting down. That is happening while returns on US ten-year bonds have been dropping from their lofty highs above 1.75% to as low as 1.62%.

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The Federal Reserve was the star of last week’s move, trying to convince markets that inflation is temporary and shrugging off increases in yields. With monetary policy unchanged, fiscal moves seem to be disrupting markets. The last stimulus checks have yet to arrive in Americans’ mailboxes and the White House is already working on a new infrastructure plan worth as much as $3 trillion.

Yeah, I’m the taxman

That would be 60% more than the covid relief package that totaled nearly $1.9 trillion, but this proposed move has another significant difference – it is set to be partially funded by tax increases. According to Jeff Stein of the Washington Post, corporate taxes would jump from 21% to 28%, the top income tax would advance from 37% to 39.6%, and new levees would be imposed on inheritance and large investment gains.

If new expenditure is – at least partially – paid for by new income rather than solely by debt issuance, the Treasury will not flood markets with bonds. Fewer bonds mean they are worth more – hence yields are lower. That is especially true for longer-term borrowing.

On the other hand, investment in infrastructure implies more government procurement, additional public, and private jobs, and potentially also higher inflation. If the economy heats up in the medium term, the Federal Reserve may have to raise interest rates sooner rather than later. In turn, that has implications for the dollar in the short term – to the upside.

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