Equity market sentiment is declining, yet the US dollar remains unaffected. Concerns are growing that current tariff policies may drive capital away from the United States.
As a result, many market participants are seeking refuge in bonds, causing 10-year yields to decrease by 11 basis points to 4.14%. If tariff escalations continue, projections indicate a potential decline to 3.5%, which could negatively impact the US dollar, especially in relation to the yen.
Divergence Between Equities And Currency Strength
The commentary up to now points to a clear divergence between risk appetite in equity markets and the resilience of the dollar. Equities are seeing risk-off behaviour, mostly spurred by unease surrounding trade policy shifts. Investors, concerned about the forward-looking effect of further tariffs, are moving funds towards perceived safer assets such as Treasuries. This has created fresh downward pressure on yields, with the 10-year tracking notably lower.
Analysts are starting to model scenarios where continued tariff extensions lead to even lower yields—possibly as low as 3.5%—which is not outside the realm of probability considering the pace of current developments. In currency markets, attention is increasingly turning to how this yield spread affects pairing behaviour. The dollar, while typically strong in risk-averse moments, sits at odds with declining real returns. Against the yen, this becomes especially pronounced because of comparative inflation dynamics and the Bank of Japan’s positioning.
Powell’s recent language from the Fed has only solidified the market’s conviction that rate cuts remain on the table, particularly if economic data starts to roll over. The front end of the curve is reflecting that shift, but what’s more telling is how duration demand is now being matched by overseas buying—particularly from Asia.
Yamazaki, in Tokyo, noted yesterday that Japanese pension funds have begun increasing hedged purchases of longer-dated Treasuries, possibly anticipating further currency appreciation. That kind of flow tends to reinforce the dollar’s weakness against the yen in the medium term. Even modest Treasury inflows, if fully hedged, may lead to thin liquidity patches in spot FX—something we should remain aware of when considering next-week’s implied volatility.
Implications Across Derivatives And Volatility
Those trading path-dependent convexity structures should revisit their delta assumptions, especially in legs with short tenor attached to curve steepening. Our models indicate a revision in dollar-yen correlations not seen since 2020’s sell-off. That matters.
Short vol positions, particularly in cross-currency basis swaps, are becoming more exposed to asymmetrical repricing. Swaps desks at European banks have already started repositioning—focused particularly on five-year buckets—and we’ve seen several unwind trades cross late yesterday in Frankfurt. For those holding directional trades between currencies with high policy divergence, extra caution is warranted.
What we’re watching now, especially through the lens of next week’s core CPI release in the US, is whether breakevens start to separate from real yields more dramatically. If that divergence gains pace, FX-flow rebalancing could amplify, complicating positioning. Market makers should take note of stop-loss triggers given current vol targeting strategies observed in large pension fund activity.
What can be said plainly is this: policy uncertainty is now being priced into safe havens more aggressively than risk assets. We’ve adjusted exposure accordingly, cutting long-duration exposure and rotating into more stable implied-carry trades. The returns may be lower, yes, but risk management in this environment demands precision.
From a derivatives angle, calendar spreads and butterfly structures are becoming more prominent, acting as a hedge against volatility clusters. With tail risks now appearing less remote, we prefer structures that maintain optionality without excessive funding cost.
Hedge ratios need rebalancing more frequently given the speed of rate repricing. Short-dated gamma sits well above normal, so even small events are triggering meaningful deltas intraweek. Traders need to calibrate for these moves or risk steep drawdowns.
We’re staying light on outright positions, favouring options to play directional views. The goal right now is simple: protect capital while waiting for the next dislocation, which—if current macro continues—won’t wait too long.
