Keep Holding the USD Longs

The ongoing US Treasury sell-off persists, creating a sense that a significant development is on the horizon. Increased volatility across various markets and broader credit spreads strongly encourages a cautious approach. In the present economic climate, this translates to maintaining a strong position in the US dollar.

USD: No point catching a falling knife in the bond market.

Global financial markets are still grappling with the ongoing US Treasury sell-off. The 10-year yield surged to 4.85% overnight, with bond strategists attributing this development to the revaluation of the Federal Reserve's multi-year monetary policy trajectory as the primary catalyst for the bond market's downturn. Forward markets are currently pricing the lowest point in the Fed's cycle, anticipated to occur in two to three years, at over 4.50%. This contrasts with the 3.68% estimate at the beginning of September. This recalibration has been spurred by a consistent stream of robust US economic data, exemplified by the recent August JOLTS job openings report, further endorsing a hawkish stance from the Federal Reserve.

Notably, Fed hawk Michelle Bowman, who earlier in the week advocated for multiple additional interest rate hikes. Today's agenda also includes the release of the Initial Jobless Claims report (though it's considered somewhat unreliable).

Turning to the bond market and its implications for the FX market, there's a growing discussion surrounding the 'term premium' in the US Treasury market. It has recently turned positive for the first time since early 2021. The term premium represents the extra compensation demanded by investors for holding a bond, factoring in elements like inflation and fiscal risks. Prior to the Federal Reserve's quantitative easing campaign in 2008/09, the US 10-year Treasury traded with a term premium ranging from +100bp to +300bp. Given this recent shift back into positive territory, it's understandable that investors hesitate to declare a peak in Treasury yields.

This marked increase in the risk-free rate is causing turbulence in global markets. Cross-market volatility is on the rise, prompting an unwinding of carry trade strategies. Notably, the Mexican peso, once a favourite of the carry trade, is experiencing significant pressure. The USD/MXN pair could potentially correct to the 18.50/70 range before stability returns. An unwind of carry trade positions is likely to support the Japanese yen and present challenges for other popular high-yield currencies in regions such as Latin America (Brazil and Colombia), Europe (Hungary), and Asia (Indonesia). Meanwhile, widening credit spreads, exemplified by the CDX high yield index approaching March levels, signal potential stress in equity markets. Such movements could inflict further hardship on struggling emerging markets, with Egypt seemingly on the brink of another major currency devaluation.

In light of these circumstances, there appears to be little incentive to sell the US dollar at the moment, barring an unexpected downturn in ISM services data that we haven’t seen this night. The 106.70 level now serves as support for the DXY index, and the overall trend continues to point toward 108.

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