As Treasury yields have picked up in the past two weeks, we have seen the USD also strengthening once more. With the US debt ceiling having been hit, politicians remain locked in negotiations to prevent what would surely be a chaotic default. This may have been impacting very short-duration T-bills but further out the curve, there is little real impact.
As markets have increasingly positioned towards a resolution on the debt ceiling, Treasury yields have risen and this is driving a USD rally. This is playing out across major forex.
- The growing prospect of a June hike lifts US yields
- The USD is gaining with US yields moving higher
- There are key breaks seen on EUR/USD and USD/JPY
The prospects of further Fed rate hikes are rising
Resolving the debt ceiling issue is not a given. There is still a possibility that US politicians could massively shoot themselves (and the global financial system) in the foot, but markets are still taking it that the situation will be resolved and they can move on.
This is certainly what Federal Reserve interest rate futures are telling us. The prospects of further rate hikes have increased in the past couple of weeks. The Fed Funds futures curve is pricing around 10 to 15 basis points of further hikes. This is not as much as another 25bps but the door is now very much open to further hikes.
With CME Group FedWatch pricing around a 45% probability of rates being 25bps higher in the next two meetings, this is fuelling a stronger USD. Notably, the July FOMC meeting also has a small (but growing) probability starting to be priced in for a 50bps hike too.
There have also been comments from arch-hawk on the FOMC, James Bullard, who suggested that another two hikes could be needed this year to curb inflation. Now, it is important to remember that Bullard does not have a vote on the FOMC this year. However, seven of the eleven voters do come with what is considered to be a hawkish bias. Even if Bullard sits at the extreme, it could be indicative that at least one more rate hike could be coming in the next two meetings.
Higher yields drive a stronger USD
The real yield of US Government bonds has been driving higher in the past two weeks. The debt ceiling progress and hawkish Fed speak are playing a role in this move.
We continue to see a strong positive correlation between the US Dollar Index and the 10-year Treasury Inflation-Protected Securities. The average correlation for the past 12 months is around +0.60 but the 21-day Correlation currently sits at a very strong 0.86.
Real yields moving higher have been a key reason behind a stronger USD in recent weeks. If this continues, then the USD will likely continue to strengthen.
Key breaking moves seen on major forex pairs – EUR/USD breaking lower
This USD strength is having a significant impact on the outlook for major forex pairs. This is seen most acutely in the breakdown in EUR/USD and the break higher in USD/JPY. From a technical analysis perspective, these are key moves.
Starting with the correction on EUR/USD. The market has fallen decisively over the past two weeks, forming lower highs and lower lows. The move has broken the big 8-month uptrend that has been driving the market higher since September.
The correction has also broken through important near to medium-term supports. These old supports are now a basis of the overhead supply of the old bulls of the uptrend, leaving resistance between 1.0830/1.0940. With the 21-day moving average falling and the underside of the old uptrend also a basis of resistance this is now a key area that could now become a near-term sell zone for any attempted rebounds. If there is another lower high around here it would open for a deeper correction back towards the key January/March lows between 1.0482/1.0514.
I do not believe this marks the beginning of a big USD bull run. However, this is in keeping with what I see as a near to medium-term USD rally that begins to tail off again. The result is that EUR/USD is likely to build a trading range between 1.0480/1.1095.
USD/JPY breaking higher, but it comes with a caveat
The USD rally has also driven a key upside break on USD/JPY. A key move above resistance at 138.17 has completed a base pattern and is a key turnaround in the outlook.
However, I am wary of chasing this one higher from here. Looking at the momentum on the daily Relative Strength Index, there is strength but arguably limited upside potential in the immediate breakout. I would favour looking to buy into weakness towards the rising 21-day moving average (currently 135.92), with the two-month uptrend also a basis of support (further back at 134.75).
The next key resistance levels that are to be tested come in at 139.90 and then more considerably at 142.25. If Treasury yields continue to track higher, there is a very real prospect of these being seen in the coming weeks.
