What If The Bond Bubble Bursts?

FX: If The Bond Bubble Bursts

It may be the dog days of summer but there is a quiet trend underway in the financial markets. U.S. 10-year Treasury yields increased five out of the last six trading days, reaching a two-year high of 2.89% intraday. The 3% mark is now within striking distance and there is a reasonable chance bond traders will make it their target. The bubble is deflating in bonds leading investors around the world to wonder if the bubble is finally bursting. Talk of a potential bond bubble burst has been happening for years but it was only in the past four months that we seen some significant moves in yields. The bubble in bonds was created by the Federal Reserve’s massive Quantitative Easing program and the recent sell-off was triggered by the central bank’s discussions about reducing their amount of monthly bond purchases. If the bond bubble burst, it won’t be pretty for equities and currencies or the U.S. economy, which is exactly the reason why the Fed will do everything in their power to avoid it. The higher U.S. yields rise, the stronger and more vocal the central bank could become on their commitment to buy bonds. While we still believe the Fed will taper next month, we also feel that they will vigorously downplay the significance of the decision with the pure goal of adding two-way action to the move in yields and it is this possibility that could be limiting the movement in currencies and equities. The dollar rose against some but not all major currencies today and U.S. stocks are down only slightly. No U.S. economic reports were released today and no market moving releases are on the calendar for tomorrow, leaving our focus squarely on U.S. yields. For the time being, we expect U.S. yields to test 3%, which should lend support to the dollar.

There is just one month left before the September FOMC meeting where the central bank is widely expected to reduce the amount of bonds purchased. The moves in Treasuries tell us that Wall Street expects the first reduction to be made next month. Yet the decision is not a done deal because recent economic data has been weak which makes investors particularly sensitive to the FOMC minutes and the central bank summit in Jackson Hole at the end of the week. We will be looking at the July minutes for potential details on the process for tapering as well as the level of conviction within the central bank. We feel that in general, the message from Fed Presidents have been clear – most of them support some type of action over the next three months with more leaning towards a sooner vs. later move. If the minutes are hawkish with more members supporting a move despite recent data disappointments, the U.S. dollar could finally see some upside momentum that could keep the EUR/USD, GBP/USD, AUD/USD and NZD/USD in their recent ranges. As for the annual monetary policy symposium in Jackson Hole on Thursday and Friday, comments from policymakers could be interesting, but market-moving comments should be limited because Fed Chairman Ben Bernanke won’t be attending. Two months ago, he dismissed the significance of the meeting by saying, “There’s a perception that the Jackson Hole conference is a Federal Reserve system-wide conference; it’s not” which is why we don’t expect any fireworks.

AUD: What To Expect From RBA Minutes

The most significant event risk over the next 24 hours will be the minutes from the last Reserve Bank of Australia meeting. If you recall, the central bank cut interest rates by 25bp earlier this month but instead of weakening, the Australian dollar traded higher. This counterintuitive price action was caused by the neutral tone of the RBA statement. The central bank failed to provide an update on their outlook for China and the mining sector, which traders interpreted to mean that the central bank is not considering additional rate cuts at the time. It will be interesting to see if more details are shared in the minutes. We know that the Reserve Bank is concerned about domestic growth and there have been plenty of weak economic releases to support their grim outlook. Inflation expectations are low despite the 15% decline in the currency this year. The RBA also still felt that the exchange rate is too high which could mean they would be more comfortable with an exchange rate between 0.85 to 0.80 cents against the U.S. dollar. We expect the RBA to maintain a dovish tone and if we are right, the AUD could resume its slide. However if the statement is neutral with no mention of the downside risks or the prospect of another rate cut, we could see a significant short squeeze in the AUD. According to the latest CFTC IMM report released on Friday, speculators reduced their short AUD/USD positions but overall positioning is still very net short. Both the Australian and New Zealand dollars declined on the back of broad dollar strength despite stronger than expected New Zealand data. Service sector activity grew at its fastest pace in nine months while output prices ticked up in the second quarter. Compared to Australia, the New Zealand economy is faring much better and for this reason we expect further losses in AUD/NZD.

EUR: Consolidation Below 1.34 Continues

After ending last week virtually unchanged against the U.S. dollar, EUR/USD spent another day quietly consolidating below the pivotal 1.34 level. No economic data was released from the region and the only comments picked up by the wires were from German Finance Minister Schaeuble who said Europe is on the right path to solving their crisis but the problems are not yet resolved. These comments were made ahead of elections on September 22. Angela Merkel’s government has a 50% chance of being re-elected and Schaeuble who has served as her Finance Minister throughout the debt crisis warned of the uncertainty that could come with a change in government. Political uncertainty is rarely good for a country’s currency but after having served as the Chancellor of Germany for the past eight years, Angela Merkel is widely touted as the Queen of the euro zone or the “mum” of Germany. Her steady hand gives her a chance of victory. Thursday’s euro-zone PMI numbers are the most important event risks for the euro this week because the currency pair’s resilience has been largely tied to recent upside surprises in euro-zone data. Manufacturing and service sector activity is expected to grow at a stronger pace in the month of August and if the data is good enough, it could take the EUR/USD above 1.34.

GBP: Shrugs Off Seasonal Decline In House Prices

Despite a decline in house prices, the British pound continued to trade higher against all of the major currencies. According to online property website Rightmove, house prices dropped 1.8% in the month of August. A quiet summer season forced home sellers in the city of London to drop prices by 2.8%, which is normal according to the director of Rightmove. He says it’s a “down-time rather than a downturn.” The drop in house prices was the first for the year and given the recent performance of the U.K. economy, we side with Rightmove who believes the drop will temporary. Yet not everyone is convinced that the outlook for the U.K. economy has brightened with the recent improvement in U.K. data. According to the Confederation of British Industry, the largest business lobby group in the nation, “Britain’s recovery will not be sustainable until the economy has rebalanced towards net exports and investment.” However they still boosted their growth forecast for 2013 and 2014. We continue to believe that the GBP/USD will hit its June high of 1.5750 but a strong sell-off in the U.S. dollar is needed to drive the currency pair beyond that rate.

JPY: Trade Deficit Balloons To Third Largest On Record

It was a mixed day for the Japanese Yen, which held steady against the U.S. dollar, strengthened against the Australian and New Zealand dollars and weakened against the euro, British pound and Swiss Franc. Considering the continued move higher in U.S. yields, we expected USD/JPY to trend higher but unfortunately there has been very little upside momentum in the pair. Last night’s Japanese trade numbers were the most important event risk released over the past 24 hours. The country’s trade deficit ballooned in the month of July to 1.024 trillion from 182.3 billion. This was the largest deficit on record and it illustrates the improvements in Japan’s economy and how the strength of the Yen in July affected trade activity. Exports rose 12.2% and imports jumped 19.6%. As an export dependent economy, Japan needs a weaker currency to fuel a stronger recovery. So far, we have seen very little improvement in the export sector and because of that, the Bank of Japan still has a long way to go.

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