FX Update: Yields spike anew. But when does it get really serious?
Head of FX Strategy
Summary: US treasury yields spiked a bit more impressively yesterday as the entire curve from five years on out rose aggressively to new cycle highs. Markets finally responded a bit more broadly to the development even if the USD move higher on the back of this development was rather modest in broad terms. From here, we will watch out for a whiplash-inducing trend shift across FX if risk sentiment deteriorates suddenly on the back of further yield rises.
FX Trading focus: USD nods its head at yield spike, when does it get more serious?
Yesterday I said that it was “too early to discuss a sharp rise in US yields” but after yesterday’s action in the US treasury market, it is more fair to say that the treasury market has thrown down the gauntlet here if yield momentum continues higher after this break. Rather important to point out, as I did in this morning’s Saxo Market Call podcast, that the yield move yesterday was more profound, both due to the size of the move, but also because the entire curve from five years on out lifted aggressively (the rise in the 5-year US treasury benchmarks yield of 8 bps nearly matching the rise in the 30-yr benchmark yield of 9 bps) and that the MOVE index, a measure of US treasury market volatility, spiked far more than it has done in a long while. As my colleague Ole Hansen would say, this is “setting a cat amongst the pigeons”, even if the market reaction has proven somewhat restrained thus far. The US dollar did poke higher and the move in USDJPY above key resistance was notable, but elsewhere, the move will only extend aggressively if the US yield rise begins to spark a larger scale sell-off in risky assets.
So I don’t know if we have set something big in motion here and now, but the bigger shift that does likely await somewhere down the road is one in which equities and bonds begin moving up and down together, a situation that would super-charge volatility levels across markets, even into FX. This almost has to happen eventually if Fed policy remains status quo, because staggering US budget deficits and treasury issuance will not be absorbed well by US savers beyond Q2 or at the latest beyond Q3. By the laws of supply and demand, yields will then rise if left to the market discovery. To keep yields from heading vastly higher and wiping out the economy, then, the Fed will inevitably have to vastly expand its QE (which it will involuntarily do once it moves to “the next level” by capping yields on treasuries, or so-called yield curve control, a situation that would see it effectively losing control of the size of its balance sheet). But when does all of this happen and in what order? These are the most important questions.
So there are perhaps two ways that markets and FX might develop from here:
Scenario 1 – the slow burn. if the yield rise slows, but persists, while risk sentiment remains stable to positive, the USD would likely roll over again, possibly with the USDJPY trading more or less sideways to slightly higher and EURUSD somewhat boring while EM and commodity currencies rise strongly again as markets . Eventually, however, yields rise to a level that crashes sentiment and spikes the USD higher (and possibly the JPY as well) while the equity market, the Fed’s undeclared third mandate, suffers an ugly consolidation. The Fed comes riding in to the rescue once more, this time with yield curve control, etc…
Scenario 2- the “Big Oops”: This is simply Scenario 1, but front-loaded with a further spike higher in US yields that crashes sentiment quickly and more violently, front-loading the volatility and prompting a quicker response from the Fed on yield curve control. The risk of the Big Oops has been enhanced by the degree of leverage in markets and dangerous complacency about liquidity conditions available on the assumption that central banks have the markets’ back.
Obviously, there are all manner of shades of gray between the scenarios. A Scenario 3 might even be possible, in which yields simply fall of their own accord first, either because the global markets go in the tank on concerns for the growth outlook. This feels less likely as it is hard to believe that fiscal forcing will ever slow from this point forward, so even if the real growth outlook may pick up slowly or even suffer badly beyond the immediate boost from the end of Covid lockdowns, the inflation outlook is likely undergoing a secular shift if we’re right that there is no turning back on forcing nominal GDP higher and deleveraging the global economy via ever expanding fiscal policy.
In many ways, EURUSD ought to be quite sensitive to a global spike in yields just as USDJPY is, given that ECB bond buying this year will more than cover net issuance, meaning that price discovery is far more limited in European sovereign yields, even if they have perked up to a degree recently as well. Sure, over time, higher US yields relative to Europe don’t have to mean a lower EURUSD if the realized inflation levels in the US pick up steam from here, resulting in real interest rates that are more negative than in Europe. But for now, even real US yields have risen on this latest blitz of treasury selling, and a continuation of the spike at anything even approaching the recent velocity could support the greenback and push EURUSD over the edge of 1.2000 and thus into the old range down toward 1.1600. Too early to make the call, but US treasury yields and risk appetite, as noted in the scenarios above, are the key coincident indicators for EURUSD direction.
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