US Dollar Back On Top As Yields Rise

Two issues are driving markets and both are playing negatively for sentiment; the rise in G7 bond yields and the outcome of the EU summit. At a time when G7 bond yields have been pushing higher the poor response to the US $32 billion 7-year note sale contributed to a further increase in yield. The sale resulted in a yield of 3.374%, which was higher than expected, and a bid/cover ratio of 2.61. A combination of large US Treasury supply, medium term funding issues and signs of improving growth suggest no let up for US Treasuries.

The most reactive currency to yield differentials is currently USD/JPY. The 1-month correlation between USD/JPY and US/Japan bond yield differentials is a high 0.85. The spike in US 10-year Treasury yields especially relative to JGB yields (by around 21 basis points this week) is the main contributor to the jump in USD/JPY over recent days. Given the bearish outlook for US bonds in the near term, it suggests more upside for USD/JPY but also increasingly for other currencies against the USD as the importance of yield increases. Immediate USD/JPY technical resistance is seen around 93.21, with support at 91.87.

The other event of note yesterday was developments surrounding Greece in the European Union summit though in truth it was probably the strong comments by ECB President Trichet that had the bigger impact on EUR sentiment. The final EU communiqué noted the readiness for bilateral loans to Greece and substantial International Monetary Fund (IMF) financing in a Greek aid mechanism. Importantly and a likely sop to Germany, any aid will not contain a subsidy for Greece. Aid by the EU and IMF will only be provided in the event of “very serious difficulties”.

The EU agreement means that no money will be forthcoming immediately, but at least there will be a back stop should Greece have financing difficulties over coming weeks, which will act as an important safety net ahead of substantial Greek debt rollovers. This news was supplemented by the fact that ECB will not raise its minimum collateral requirements at the end of the year, which means that Greek debt will not be excluded in the event of a ratings downgrade. This is good news for Greece.

The combination of the fact that Greece will have to borrow money only at market rates, ongoing worries about other EU countries fiscal problems and European Central Bank (ECB) President Trichet putting somewhat of a dampener on sentiment by criticizing IMF involvement in the deal, will keep the EUR under pressure. Although Trichet later reversed his comments, the damage was already done and any relief to EUR/USD will be short-lived. The currency pair is increasingly poised for a further downside move, with the next target at 1.3213 on the path towards an eventual test of 1.3000.

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