One of the biggest conundrums in the FX market this month was the breakdown in the relationship between the U.S. dollar and Treasury yields. Over the past few years, USD/JPY has had a very strong correlation with 10 year yields but during the first few weeks of August, this relationship completely broke down. Yields started to rise at a relatively quick pace but USD/JPY failed to follow suit. Last week, the relationship reverted back to normal with USD/JPY suddenly breaking higher and rising for 5 consecutive trading days. This was the longest stretch of strength in USD/JPY since February and marked a dramatic shift in trading sentiment.

Why did the correlation resume? The answer is simple. The Federal Reserve kept their monetary policy stance virtually unchanged when they last met, leaving investors confused about whether QE3 was on or off the table. Some argued that QE3 was simply postponed to September when the Fed would have a better opportunity to prepare the market for a move. Others believed that economic conditions have not deteriorated enough to warrant additional stimulus. Since then we have seen a number of positive economic reports that will make it difficult for the central bank to justify a third round of asset purchases. The first piece of good news was the non-farm payrolls report which snapped back strongly in July. This was followed by stronger retail sales, hotter producer prices and then stronger consumer confidence. Bond traders responded relatively quickly, adjusting their QE3 trades as data was released but it took longer for currency traders to be convinced that the Fed would not stand down next month.

What the Rally in U.S. Treasury Yields Tell Us

The simultaneous rally in Treasury yields, USD/JPY and U.S. stocks tell us that the low volatility environment has given investors the confidence to dip their toes back into equities. It is clear that money is being moved out of the bond market and into the stock market. There is room for yields to head higher this week if investors start to price in the possibility of less pessimistic or more optimistic comments from Bernanke at Jackson Hole later this month. The FOMC minutes this week should be as unsatisfying as the last Federal Reserve meeting. There’s no consensus in the central bank on the need for QE3 and the minutes will reflect that. Instead, we will be listening more closely to the comments made by FOMC voter Lockhart who endorsed another round of QE back in July. If he moves away from that call even slightly, there’s a good chance Bernanke could do so as well in Jackson Hole. USD/JPY could continue to track yields higher especially if there are no major disappointments in U.S. data and equities continue to rally. Investors have plenty of reasons to hold onto their optimism in the near term including:

• First Rebound in Retail Sales in 4 Months
• Job Growth Exceeds 150k in July
• Consumer Confidence Picks Up
• Hotter Producer Prices
• Spanish Bond Yields Drop to 4 Month Lows
• US Stocks Rise to 4.5 Year High

What Could Cause the USD/JPY – US Yield Relationship to Break Again?

However the risk of another breakdown in the USD/JPY – US Yield relationship still exists. If investors find a reason to seek refuge in U.S. Treasuries once again yields could fall and USD/JPY could hold steady because the dollar and the yen are both safe haven currencies. The fiscal cliff poses a different problem. If rating agencies believes that the U.S. deserves a credit warning or even a downgrade, U.S. Treasuries could be sold sending yields higher. In this situation, the uncertainty could also drive investors out of the U.S. dollar. Finally, the Federal Reserve won’t be happy with the rise in Treasury yields. Their central strategy for monetary policy is to drive yields lower and the recent bump up in the 10 year yield erases 2.5 months worth of effort. While we don’t believe there will be QE3 in September, the Federal Reserve could take other measures to keep a lid on yields if they continue to rise. This would be negative for USD/JPY but the risk of intervention from the Bank of Japan could limit the slide in the currency.

Last week’s rally in USD/JPY took the pair close to a very important resistance level. It will be difficult for the currency pair to break above its 100-day SMA and above 80.50, a level that has contained the USD/JPY’s rise for the past 3 months without a major catalyst. Unfortunately we don’t expect that catalyst to come in the next week, when there is very little U.S., European or Japanese data on the calendar.

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