US Dollar: Bearish regime reinforced by bull flattener – TD Securities

TD Securities strategists have observed that the recent announcement from the United States Treasury, aimed at bolstering long-term bond purchases, has intensified the bearish trend for the US Dollar. By analyzing data from the US Dollar Index (DXY), the S&P 500 (SPX), and 5-year to 30-year Treasury yields (UST 5s30s) since 1999, they found that a bull flattening in the yield curve, combined with stronger US equities, typically hampers the Dollar's performance.

However, when US equities rise during a UST bull flattening, the Dollar usually experiences only a slight decline, contrary to the commonly expected sharp rally.

The combination of a bull flattening in the UST curve and robust US equities ranks as the second rarest scenario among the eight possible UST curve dynamics and equity situations. Following the Treasury's buyback announcement on August 19, the long-end 30-year Treasury yield fell by nearly 10 basis points in a single day. This development contributed to a bull flattening curve dynamic.

Traditionally, a bull flattening in the UST curve, resulting from US risk-off shocks, would lead to increased demand for long-dated Treasuries and a stronger Dollar. However, when US equities perform well alongside a UST bull flattening, the Dollar tends to weaken by about 0.3%. This rare occurrence has been the second least frequent combination among the eight possible UST curve dynamics and equity scenarios.

The USD was on the verge of a bearish turn after muted Consumer Price Index (CPI) and negative retail sales data in July. Heightened concerns about US institutional credibility and the potential for financial repression after the Treasury's buyback announcement solidified the prevailing bearish sentiment for the Dollar. Although it was anticipated that the USD would eventually revert to a bearish regime later in the second half of 2026, the shift has occurred earlier than expected.

Conversely, the Dollar could rally if a significant US equity shock were to occur while the UST curve does not steepen further. Historically, a bull steepening curve dynamic has been the most bearish for the Dollar and could overpower the effects of equity performance. This scenario tends to emerge amid Fed rate cuts in Q3 2024 and Q4 2025. For now, market consensus expectations remain bullish for US equities, but this scenario poses the greatest tail risk for the USD in 2026.

Currently, market participants are gradually discounting near-term Federal Reserve rate hike expectations following poor US data so far in Q3, and the base case is also for the Fed to maintain its current stance.