Follow bonds or short rates for USD currency play?

Short rates in the US suggests that the dollar should be a funding currency which will continue the downward pressure on the dollar. Rates are decidedly against holding USD versus almost all other interest rates around the world. The short rate story is to sell dollars and buy any other currency.However, if you look at the steepness of the yield curve and the long bond, you are getting a slightly different picture. With 10-year US yields at 3.60, the advantage is for the US versus EUR, JPY and a number of other G10 countries. There is not the same carry story. In fact, there may be a desire to hold US bonds versus other countries. The fixed income markets are providing mixed signals.

This story gets a bit more confusing when you look at the data. Uncovered interest rate parity is more likely to hold for bonds than for short rates. Higher rates suggest you should be a buyer of the currency with short maturities. For bonds, higher rates means higher inflation expectations which will lead to a a currency depreciation. The forward bias puzzle is less apparent. Higher rates may also be necessary to maintain currency levels as compensation for potential bond-holder risk.

Flow dynamics for bonds include concerns over asset substitutability and right now rates are higher in the US to attract the necessary funds to meet shortfalls between savings and investments. The poor performance of bonds during 2009 is telling the market that higher yield are necessary to make Treasury bonds attractive. Carry dynamics have to enhanced or tempered by the shape of the yield curve and views on inflation.