New Yield Highs Good For USD, Not The Fed

The U.S. dollar traded sharply higher this morning on the back of better than expected weekly jobless claims and new highs in 10 year Treasury yields. Stocks on the other hand are performing poorly because the drop in claims and rise in yields is also consistent with increased expectations for tapering. The last time 10-year Treasury yields hit 2.8% was in July 2011 and in the past 3.5 months, yields have increased approximately 120 basis points. The rapid rise in yields could make the Federal Reserve nervous especially if it nears the 2.9% mark. In his speech this morning, FOMC Voter and Fed President Bullard said higher "10-year Treasury note yield is a concern." The real question is whether this would affect the central bank's decision to taper and we believe that it could. If come September 10-year Treasury yields are at 3% or higher, the amount of reduction in asset purchases could be smaller and the Fed will downplay expectations for additional tapering. December is still an option but its proximity to the holidays makes it a less desirable time to reduce stimulus than September.

Strong U.S. Data
The labor market continues to show signs of recovery with weekly jobless claims falling to 320K from 335K, the lowest level since October 2007. The four-week moving average is also closing in on its six-year low as the amount of layoffs continues to slow. The problem is hiring and while the unemployment rate has declined, the number of jobs created each month is barely enough to offset the number of new entrants. Nonetheless the fact that claims are moving in the right direction was enough to lift the dollar. Aside from jobless claims, the rest of today's economic reports were tepid. Manufacturing activity, inflationary pressures and industrial production deteriorated in the month of July while foreigners were net sellers of U.S. dollars in June. Weak demand is keeping price pressures at bay with CPI and CPI ex food and energy rising only 0.2%. The Empire State Manufacturing survey slipped to 8.24 from 9.46, the Philadelphia Fed index fell to 9.30 from 19.80 while industrial production remained flat after growing 0.2% the previous month.

Looking Ahead
We still expect the dollar to remain bid but further gains will hinge on Friday's University of Michigan Consumer Sentiment index and a continued rise in U.S. yields.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.