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The global bond yield spike and its implications for FX

-->The global bond yield spike and its implications for FX                       
  • USD: The US bond yields spike and its impact last week’s aggressive rise in US Treasuries (UST) yields sees the UST 10Yr yield touching a 1.60% high before ending the week at 1.40%. Importantly though, UST real yields also surge, the 10Yrs ending the week near -60bp (~40bp higher this month). This move up in US real yields causes significant weakness in risk assets – equities, credit, commodities and FX (AUD, NZD, CAD, GBP and EMFX). Notably, the yield spike comes in spite of Fed assurance that there is no rush to normalize policy settings. Investors though seem to focus more on the Fed’s reluctance to push back on the rising yields with Fed Chair Powell and others seeing this as a reflection of the improved US economic outlook.  

  • USD: Inflation expectations vs real yields –  who leads further rises in US nominal yields? This matters for USD -   While earlier increases in US yields have been driven by rising inflation expectations, more recently, about 30bp of the 40bp move higher over the last month has been due to higher real yields. Citi analysts team sees core PCE overshooting to  the 2.2% level by mid-year.  With US 10Yr real yields currently at -0.60bp and US 10Yr nominal yield ending last week at 1.4%, US rates markets already seem to be discounting longer term inflation expectations (UST nominal – real yield) at 2.0%. Citi analysts though now forecast the US 10Yr nominal yield to move to 2% by year-end (ie. a further 60bp rise from last week’s close at 1.4%). This implies that 20bp (one third) of a likely 60bp move up in UST nominal 10Yr yields to year-end may be led by the inflation expectations component as markets adjust to discounting a higher US core PCE from 2.0 to 2.2% (as per the Citi analysts forecast) while the remainder (40bp – two thirds) of the move up could be led by US real yields. -  such a large move by US real yields could support a stronger USD outlook.   

  • USD: But are Citi analyst forecasts for higher US yields (nominal and real) credible? - Citi analysts note that their out-of-consensus call for the Fed to taper asset purchases in Q4 2021 and begin raising rates in December 2022 is consistent with the more recent move up in UST yields even if that move has come sooner than expected. The team also notes that the Fed has yet to push back meaningfully on rising rates which adds to the risk of the Fed delivering on its “substantial further progress” sooner, implying earlier tapering. Citi analysts also note that front end US rates have now re-calibrated substantially, with markets pricing in an 80% chance of a Fed 25bp rate hike by end of 2022. It seems that investors are increasingly challenge the “lower for longer” thesis on Fed policy and possibly coming on board to the more hawkish views presented by Citi analysts.      

 

What about bond yields in the other major economic blocs?  

  • EUR: Yields have also risen in the rest of the G10 space less so as other global central banks have been less welcoming than the Fed. ECB President Lagarde has been quick to indicate (Friday) that higher yields are being closely monitored. The RBA has gone further by conducting an unscheduled bond purchase on Friday to keep yields capped while BOJ reminded investors that Japanese yields remain very low relative to elsewhere. In the euro area, Citi analysts note financial conditions are loose, but only just, and significantly less so than a year ago. Arresting the uptrend in euro area rates therefore, may now be ECB’s priority and could see ECB more active in using its PEPP (asset purchases) and conducting a comprehensive review of euro area financial conditions and its components at the March 10-11 board meeting – potential headwinds for EUR against USD.  

  • CNY: Widening real yield differentials may favor USD should yields continue to rise - higher relative real yields in the US could be positive for USD in the G10 FX space. This is somewhat in contrast to the recent period, when global risk-on and rising inflation expectations meant  nominal yields could rise without leading to dollar strength. Citi analysts are also cautious on Asia EMFX and even on CNY as it also responds to broad USD moves resulting from higher US bond real yields.          

 

Week Ahead    

  • USD: More Fed speak – Chair Powell and Governor Brainard in focus again – Citi analysts still think Chair Powell will, for the most part, continue to see the rise in US bond yields as indicative of a firming outlook, leaving interest rate markets free to continue to price higher real rates. Other Fed speakers this week include Fed President Williams, Bostic, Mester, Kashkari, Daly, Harker and Evans. The US House is also likely to pass its fiscal bill probably on Friday along party lines.  
  • USD: US nonfarm Payrolls – Citi: 410k, median: 150k, prior: 49k; Average Hourly Earnings MoM – Citi: 0.0%, median: 0.2%, prior: 0.2%; Unemployment Rate – Citi: 6.4%, median: 6.4%, prior: 6.3% - after two months of much softer employment reports, Citi analysts expect a solid 410k total jobs added in February and 360k private jobs and expect continued upside in US jobs in coming months. The team expects average hourly earnings to be flat in February and a modest increase in the unemployment rate to 6.4%. This reflects expectations for some increased labor force participation.
  • AUD: RBA March Board Meeting - Citi cash rate target forecast; +10bps, Previous; +10bps; Citi 3-year yield target forecast; +10bps, Previous; +10bps - RBA is unlikely to tweak any of its major policy instruments, following February’s announcement of an extension of its LSAP program (asset purchases) by $AU100bn when it expires in April. Australian bond yields though have pushed higher with US yields, forcing the RBA to unexpectedly defend its 3Yr Yield – Curve – Control (YCC) target for the first time since December on Friday. This creates a potentially dovish setting for the RBA policy statement this week in which it is likely to reinforce its commitment to continue defending its 3Yr YCC target. Citi analysts also maintain the RBA will likely commit to additional LSAP later this year and is unlikely to prematurely exit its YCC target, but instead, possibly roll forward to purchasing the November 2024 bond which would be a de-facto extension of forward guidance on the cash rate.         

 

This is an extract from the Daily Currency Update, dated March 1, 2021. Please approach a Citigold Relationship Manager if you would like more information.

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