Rise in Bond Yields Drives Dollar Strength

Highlights
The US dollar headed higher amid a rise in tension on the Korean Peninsula and more importantly a surge in US bond yields with the 10-year increasing by 7bp today. The euro tested levels under $1.320 but sovereign support, coupled with better-than-expected German industrial production, underpinned recovery. Sterling traded at session highs after UK CBI manufacturing orders beat expectations in December. The index hit the highest levels since June 2008, which stoked UK recovery hopes and lifted the currency to $1.580 highs while EUR/GBP traded into the 0.842 area. USD/JPY continued to rise, amid increased macro interest, with the 2-and 10-year yield spread largely favoring long USD versus the yen, which is especially sensitive to the interest rate spread as the markets digest the news of the US tax cuts. Elsewhere, ahead of the Reserve Bank of New Zealand central bank announcement the kiwi is the worst performer against the dollar, falling back the NZ$0.750 area after topping out at NZ$0.757.

Global equity markets are mixed following a sharp selloff in the late afternoon North American session. Asian stocks are mostly lower as rising tension on the Korean Peninsula, coupled with the looming fears of a China rate hike, dampened sentiment. The exception was the Nikkei, up 0.9% on the day, which appears to be adhering to its tight correlation with the yen and appears to have been lifted by the nearly 0.5% gain in the USD/JPY. Meanwhile, European bourses are higher on the back of stronger economic data and the progress of the Ireland austerity budget with the Euro Stoxx 600 led by financials. The FTSE and Dax were both positive with the former up 0.6% and the latter up 0.1% led by gains in energy and financials.

Euro-zone spreads have relaxed a bit following the passage of the Irish budget with the Irish 10-year down 5bp followed by a 1bp drop in Portugal’s 10-year borrowing costs. At the same time, German 2-year notes declined, sending the yield 9bp higher, after investors bid for less than the full amount of securities offered. More specifically, this is the third auction in a row that was technically uncovered for Germany. Spain’s 10-year yield is up 4bp with Italy’s yield up 3bp. Yet the key driver for recent dollar strength has been the surge in US Treasury yields, which have increased 23bp at the 10-year tenor, 13bp at the 30-year and 5bp at the 2-year, over the past five days. Additionally, the progress of the Bush tax cuts and the recovering US economy (albeit slowly) have raised questions over the impact on future QE measures. QE, in theory, is supposed to anchor bond yields with the Fed wielding the stick of continued purchases, testing the markets resolve to sell bonds. But the tax cuts, and further fiscal measures, are fiscally stimulative, which may reduce the onus of the Fed to support the economy. Nonetheless, the rise in yields have been dollar supportive in the G10 and further selling pressure may stoke continued support for the currency. Elsewhere, Iceland cut rates to 4.5% as krona cools inflation while Brazil November m/m consumer price inflation rises to 0.83%, up from 0.75%, but below the market consensus of 0.87%.

Currency Markets

In recent weeks, the US dollar’s recovery from the Sept-Oct decline seemed to be largely a function of the deteriorating situation in Europe. U.S. economic data generally surprised on the upside, with the notable exception of the November jobs report, but growth in Q4 looks to be around the pace seen in Q3 and in any event, not sufficient to bring down the unemployment rate at a politically or economically acceptable pace. However, a new driver has been added to the mix and that is the compromise between Obama and the Republican party on tax policy. Congress still needs to pass the legislation and it may not be a sure thing given the likely resistance by many of the lame duck members, but it could be passed retroactively by the new Congress.

The dramatic backing up of US interest rates has given the dollar a new fillip on top the ongoing European financial crisis, high anxiety from the Korean peninsula, and Chinese rate hike fears encouraging some profit-taking on emerging market exposures. The tax compromise is seen by many economists as generally supportive of U.S. growth and may help shave a few tenths of a percent off the unemployment rate. Although last week concluded with the market anticipating Bernanke’s "60-Minute" interview and his reiteration that the Fed’s long-term asset purchases may be extended, there is speculation that the additional fiscal support may take some pressure off monetary policy to bear the burden. Lastly, the contrast between the fiscal austerity in Europe and the extension of tax cuts in the US, not just the 2001 and 2003 tax cuts, but also a new 2% payroll saving tax cut and the extension of unemployment benefits has rarely been starker.

Eurogroup head Juncker responds to Germany’s unEuropean stance on ebonds. Juncker told Germany’s Die Zeit that German criticism of the euro-region bonds, suggesting that it would lead to a single market interest rate, was incorrect. "We would bundle a part of the national debt at European level and service it with euro bonds", stressing that "most debts would be paid off at national interest rates". Juncker also said that Germany has shown "simple" thinking on the matter. Officials seem to be mulling the idea of refinancing some of the existing debt with eurobonds, rather than new debt, which may help to limit the resulting free-rider issue. This would to a certain extent be an extension of the European Stability fund, which will also issue joint bonds. However, Junckers public attack on Germany adds to the image of a divided euro-zone and does little to restore market confidence. Indeed, the IMF’s Dominique Strauss-Kahn has publicly criticized Europe’s case-by-case approach to problem solving, suggesting that it is not a good solution to find a solution for every country. He also expressed concerns over a two-tier Europe the risks of the euro-zone breakup if contagion fears are not mitigated.

Upcoming Economic Releases

There are no major data releases for the US but at 8:15 EST / 12:15 GMT Canada releases November’s housing starts, which are expected to rise to 173k from 167.9k in October followed by Mexico’s trade balance at 10:00 EST / 14:00 GMT. There is no consensus for the data. Events: Brazil COPOM meeting and SELIC target announcement, expected to remain at 10.75%. US to sell $25bln 56-day Bills and $21bln in 10-year notes.