London Session: Is the Wait for Treasury Yields to Move Higher Finally Over?

The dollar continues to be buoyed by the Fed’s improved outlook on the US economy and the news that most of the US’s largest banks are well-capitalised enough to withstand another recession. Even though four banks failed including Citi Bank this isn’t what the markets are concentrating on today. Yield hungry investors are helping to keep the upward momentum going as the banks that passed the tests are now free to increase dividend pay-outs and share buy backs. Even Citi Bank announced that it would be paying a dividend this year.

Fed action is foremost on everyone’s minds. Signs of stabilisation in the Eurozone (or a lack of any more bad news) along with the better tone to economic data is causing the “normalisation” trade to be put back on. In an environment where the US is picking back up and inflation is at a tolerable level then you would expect stocks to rise along with yields, especially when Treasury yields are rising from an incredible low base.

Likewise, the Vix index – Wall Street’s fear gauge – is back at the May/ June 2010 lows, which sets the stage for a prolonged rally in equities.

Only a few days ago the markets looked very sticky around some major levels like 13,000 in the Dow. However, after detecting a brighter tone in the Fed’s words that caution has been replaced with optimism. A wiser person than I said that it’s much easier to pick spot the bottom in a market than it is to spot the top – and that seems to be the case now and after a pause stocks may move higher.

The writing has been on the wall for a while for Treasury yields to bust higher. Not only is the Vix at multi-month lows and oil prices are significantly higher since the start of the year, but the cost to insure North American investment grade credit from default has been on a downtrend since late November. Usually the IG CDS index has a good inverse correlation with 10-year Treasury yields as you can see in the chart below.

However, while there are multiple influences on the bond market, make no doubt that the Fed is its master. Thus, the next question to ask is how high will the Fed want yields to go? With a huge debt burden, the US can’t really afford rates to be too high. Thus, we are watching 2.4% - the November high – with a mixture of curiosity and a bit of fear, as this could prove to be fairly hardy resistance. Since the move higher in yields is pivotal to sustain dollar gains, especially in USD/JPY, this level is definitely one to watch.

There was some other news out today to take the attention away from the Fed. The UK unemployment rate remains at an 17-year high at 8.4%. The pound has virtually no correlation with domestic issues right now and GBP/USD is testing a key support level at 1.5670. Since the dollar move seems to have momentum behind it, below here opens the way for a move back to 1.56. Gilt yields are also higher along with Treasuries, although news that the UK government is planning to issue a 100-year bond may have also put some pressure on the Gilt market.

The Norges Bank is on the opposite side of the tracks from the Fed and actually cut rates today. This caused an enormous spike in USD/NOK. It is currently testing resistance just below 5.82, above here opens the way to the 6-6.10 highs from January. The Bank sounded extremely dovish and said the bank rate could remain lower for longer, it also sounded concerned about the strength of the Nok. However, some think that the Nok is a buy on dips because of the rising oil price and the impact this will have on producer nations’ terms of trade like Norway, so we could see the market call the Norges Bank’s bluff over how committed it is to keeping rates too low for too long.

In the very short term watch 1.30 in EUR/USD. The pair is very weak within its range and as we mentioned before, now that China and Japan have depleted FX reserves the central bank reserve diversification story is one less pillar of support for the single currency. Thus this cross could be vulnerable below 1.30.

The dollar rally will run out of steam at some stage, but for now this is the major theme dominating markets. We would note that the Dollar index is currently testing 80.50, a major resistance level , and the January high, is coming up just below 82.00, so the greenback may slow as it approaches this level in the short term.