The U.S. dollar is starting the week stronger against all of the major currencies as deleveraging in the equity, bond and currency markets continue to drive investors into the arms of greenback. The rush to liquidate out of dollar funded carry trades along with renewed demand for long U.S. dollar positions has driven the mighty buck sharply higher over the past week. The recent signals of policy actions or lack thereof by the U.S. and Chinese central bank wrecked havoc on the financial markets. Even though the Federal Reserve may feel that the economy is ready for less stimulus investors are worried that fewer asset purchases in the U.S. and less liquidity in China will slow the global recovery. Despite the pullback in the SHIBOR rate, the 5.29% decline in the Shanghai Composite index overnight dragged global equities lower with U.S. stock futures pointing to a sharply weaker open. Unfortunately there are no U.S. economic reports on the calendar today to reverse the slide in stocks.

Forex traders and traders of all asset classes in general should keep a close eye on the bond market because it is ground zero for deleveraging. U.S. 10 year bond yields have broken above 2.6% today, rising another 11bp to its highest level since August 2011. With 3% yield in view, the cost of borrowing could soon reach levels that are overly oppressive for U.S. consumers and businesses. Unfortunately yields in the U.S. are not the only ones that have shot higher this morning. In Australia, 10 year bond yields jumped 27bp, in the U.K. they are up 14bp and Germany they increased 11bp. In a growing economy when risk appetite is healthy, rising bond yields could represent strength but in today’s market environment the rise in yields represent panic.

In recent years, the Federal Reserve’s ultra loose monetary policy kept a lid on yields and made U.S. dollar funded carry trades extremely attractive to global investors. However that all changed last week when Bernanke said the Fed is ready to taper asset purchases this year and end them completely by the middle of 2014. U.S. bond yields soared, stocks plummeted and the dollar shot higher. Last week marked a turning point for the greenback and the uptrend is likely to continue in the coming weeks, albeit at a more moderate pace. The next step of the cycle would be to initiate long dollar positions, which we expect to occur over the next few weeks. Previously the majority of market participants had expected the Fed to taper next year with a minority looking for this to occur in December. Now everyone has to rush to reset their expectations and position for the strong possibility of Fed action in September, leading to the potential for further gains in the dollar.

In terms of technical levels, there is a significant support level in the EUR/USD at 1.3075, where the 38.2% Fibonacci retracement of the July 2012 to January 2013 rally converge with the 50,100 and 200-day SMAs (the currency pair is testing that level as we speak). If this level is broken in a meaningful way, the next target for the EUR/USD will be 1.30. USD/JPY on the other hand is crawling towards 100 but a move to 103 would require the Japanese to buy foreign bonds. The sell-off in AUD/USD is once again stalling at 0.9165, the 38.2% Fibonacci support of the 2008 to 2011 rally that took the currency pair from 60 cents to 1.10. If this level breaks in a meaningful way, AUD/USD could tumble quickly to 90 cents.

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