Rising rates should be good for a currency. At least that's the theory. And those who believe it have been disappointed in the last few years, because just the opposite has been true. Since the financial crisis, both the dollar and treasuries have been viewed as "risk-off" assets. When it felt as though the next Eurozone country was about to fail, investors bought treasuries and the dollar. Each dollar rally would typically coincide with stronger treasury prices and lower rates. The dollar-to-interest-rate correlation became more negative as things in Europe became more uncertain. The correlation hit its lowest level (most negative) after Italy's ability to fund its government and the whole of EMU's future was brought into question in late 2011.
But recently we've had what some refer to as a "regime change". Treasuries to some extent lost their status as a "risk-off" asset (see post). The correlation between the dollar and interest rates suddenly flipped into positive territory, which is more in line with the traditional way of thinking about the relationship. In fact the correlation hit its highest level in nearly a decade. US rates recently became the "risk driver" of other asset classes.
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| Trade Weighted U.S. Dollar Index: Major Currencies (DTWEXM) vs. 10 yr treasury yield |
This regime change plays havoc with many common risk models that banks and even some asset management firms run. These models often drive trading limits, counterparty potential exposure measurements, and bank regulatory capital. The calculations tend to rely on historical relationships - sometimes over a period covering the previous two years (as prescribed by the Basel rules). At this point however some of these models are all but meaningless, as correlations among major asset classes have flipped. Yet these measures continue to be broadly used, with regulators encouraging or even requiring this practice.
So the next time you see a "value at risk" measure, ask the author how she/he addressed the recent regime change in the markets. The answer may surprise you.