The slide in the US dollar and US interest rates faded in the North American session on Monday. US participants also had a fairly relaxed initial response to news that after years of complaining, the Republicans could not agree on an alternative to the Affordable Care Act.
Many observers experience the currency market to be buffeted by many different forces. Perhaps, because, unlike other assets, currencies in their pure form do not generate a yield stream that can be modeled, they seem to be more subject to market fads. However, our work continues to show the strong relationship between the dollar and interest rate differentials. This remains our anchor.
The chances of Turnaround Tuesday materializing for the dollar will be bolstered if US interest rates stabilize. The US 2-year yield approached 1.22% yesterday before recovering. The link between the rate the Federal Reserve targets (Fed funds) and the two-year note is stronger than at the long-end of the coupon curve. The two-year yield seems unreasonably low at 1.25% with a Fed funds target range of 75-100 bp unless one does not expect more than one hike over the next seven quarters. During this period, the median view of Fed officials is for five hikes over this period.
Under Occam's Razor, one can explain the recent price action in the foreign exchange market without discussing US fiscal policy. The Fed hiked on March 15 and as is often the case, buy-the-rumor sell-the-fact activity followed—the dollar and US interest rates fell. The two-year note yield fell 17 basis points after the Fed hiked rates in December. The yield has declined 18 bp since the March cut.
The day before the Fed hiked, Bloomberg's calculation showed a nearly 54% chance of a June hike to 1.00-1.25%. A week after the Fed hiked, the odds had fallen to almost 47%. The odds have slipped a little more to 45%.
The Dollar Index fell from about 103.55 to near 99.25 in the weeks following last December's rate hike. It made a high of around 101.70 on March 15. We saw that the two-year yield had declined now as much as it did in December. If the Dollar Index did this, it would bring it toward 97.40. However, the Dollar Index has fallen for three consecutive weeks coming into this week's activity. Technical indicators are stretched, and the Slow Stochastics and RSI appear poised to turn higher.
The euro has advanced for four consecutive weeks. It extended that rally yesterday, briefly poking through $1.09. It stopped just shy of the 61.8% retracement of the losses suffered since the US election (~$1.0925). It traded above the 200-day moving average (~$1.0880) for the first time since that election, though failed to finish the North American session above it. Technical indicators are stretched. Given the technical and psychological damage, we suspect that a period of consolidation, with the $1.0800-$1.0820 offering support.
The dollar approached but held above JPY110. This is an important area for technical and psychological reasons. We note that it corresponds to the 50% retracement objective of the dollar's rally since the US election. The 61.8% retracement is found a little below JPY108.00. Ahead of that is the 200-day moving average (~JPY108.30).
The US 10-year yield peaked when Fed hiked in December near 2.64%. It fell to almost 2.30%. The 10-year yield peaked the day before the Fed hiked earlier this month near 2.63%. At the low point yesterday, before the bounce, the yield was briefly pushed below 2.35%.
Sterling has fallen only three times in the past 12 sessions coming into Tuesday's session. It has moved from the lower end of the year's range to the upper end. It faltered yesterday after it moved above $1.26. Sterling has not traded above $1.28 since early last October. Initial support is seen near $1.2550 and then $1.2520. Wednesday's notification that Article 50 of the Lisbon Treaty is a formality and widely anticipated, which is not to take away from its historic importance.
In the North American session, four Fed officials speak, including Yellen. On balance, we suspect that Fed officials cannot be particularly pleased with the market response. A seemingly simple statement noting that the Fed had recognized the uncertainty surrounding the outlook for fiscal policy and recent developments do not change that, could help steer investor attention back to mostly healthy even if not spectacular US growth dynamics.
Oil prices also recovered in North America yesterday, which supported the recovery in yields and the dollar. The $48.00-$48.50 area (basis the May light sweet futures contract) may be key to the near-term outlook.
Asian equities have begun off the session on a firm note, and this also supports the Turn Around Tuesday scenario. We had noted that the 2317 area was the next target in the S&P 500, which corresponded to the 50% retracement of this year's gain. It seemed like a reasonable target as the position adjusting ahead of the quarter-end became a more important consideration. The S&P 500 recovered after approaching it (~2322) yesterday. A move above 2350-2357 would lift the tone considerably.