US Yields & USD Continue to Correct Lower at Start of the Week
During the Asian trading session, the US dollar continued to display weakness, following a consistent decline in the dollar index over the past six days. In the previous session, the index marked its sixth consecutive day of lower closes and even reached an intraday low of 105.66. Since its peak on October 3rd at 107.35, the dollar has seen a decrease of approximately 1.6%. Concurrently, US yields have also experienced a correction. After reaching 4.89% at the end of the previous week, the 10-year US Treasury yield receded to an intraday low of 4.62% yesterday. This correction signifies the end of the persistent sell-off in the US bond market that had commenced in early September.
The initial catalyst for the decline in US Treasury yields was a surge in geopolitical tensions in the Middle East, particularly between Hamas and Israel. This heightened geopolitical turmoil prompted an increase in demand for safe-haven assets. However, investor sentiment regarding risk began to improve as market participants grew more confident that the conflict would not spread throughout the region and disrupt financial markets. In response, MSCI's ACWI global equity index rebounded by nearly 4.0% over the last five trading days.
Despite the improvement in risk sentiment, US yields have failed to rebound. This suggests that the shift in Federal Reserve (Fed) policy communication towards a more dovish stance is a significant factor behind the decline in US yields and the weakening of the US dollar. In recent weeks, there appears to have been a coordinated effort by Fed speakers to temper the sharp increase in US yields witnessed in prior months. Atlanta Fed President Bostic and San Francisco Fed President Daly reiterated a similar message. Bostic stated that there is no need to raise rates further and believes that current policy settings are conducive to achieving the 2.0% inflation target. Daly added that the recent rise in bond yields has tightened financial conditions, potentially reducing the need for additional rate hikes. However, she also noted that the neutral policy rate might have increased slightly, from, for instance, 2.50% to 3.00%. This still implies that current policy rates are relatively restrictive.
Despite the correction in US yields this week, US financial conditions remain notably tighter than they were before the summer, which should provide impetus for the Fed to maintain its current interest rates. The US rate market is currently pricing in only a modest increase of around 4 basis points for the November and December Federal Open Market Committee (FOMC) meetings, even considering the robust Non-Farm Payrolls (NFP) report for September released on last Friday. This indicates that market participants are heeding the guidance of Fed officials, who suggest that higher bond yields are effectively contributing to the slowdown of economic growth and inflation. While the upcoming release of the minutes from the September FOMC meeting might have a slightly more hawkish tone, it is unlikely to fully reverse the recent dovish recalibration that has placed downward pressure on the US dollar.
The EUR/USD has stabilized at the 1.0600 level kind of consolidating around 1.06/1.063, primarily due to a correction in the dollar, with limited bullish support coming from the euro's side. Today, the European Central Bank is set to release its inflation expectations for August. It's possible that the three-year-ahead gauge could see a slight increase from 2.4% to 2.5%. While not a significant change, this may not be well-received by policymakers and could provide marginal support to the euro.
Additionally, two ECB speakers will be sharing them view on the MP today, Elderson & Panetta. Notably, Villeroy voiced his opposition to raising reserve requirements in a recent speech.
According to my short-term fair value model, there's a possibility of the EUR/USD pair extending its upward correction to 1.0700. However, I believe this might represent the upper limit of the range unless there is a surprising soft reading in the US Consumer Price Index (CPI). In my view, a return to the 1.0500 level seems more likely in the days ahead.
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