View: US 10-year yield sets higher ‘goal’, but it will be ‘penalty’ for EM FX

Over the last three days, the world has seen some remarkable strokes from the three great players… Lionel Messi won Golden Ball (Best Player) Award Read, Cristiano Ronaldo won the Golden Boot award and Novak Djokovic won the sixth Wimbledon title. The only common point across these players is ‘Dedication’ towards their sport. Now, let’s check about another great player— the US 10-year bond yield and its dedication towards the US dollar index.

The correlation since the first week of June has been diverging despite FOMC’s revision of the dot plot and consideration of the higher expected inflation and growth in upcoming quarters. However, few points signify that bond yield will unfold its up move towards 1.75 percent to 2.20 percent over the short term and 3.00 percent over the medium term. And that will help the US dollar index to move towards 93.50-94.30 levels.

After the announcement of the FOMC policy last month, the short-term rates were seen increasing, and long-term rates were seen falling. In short, the curve was seen flattening out as future breakeven inflation was seen cooling off as the market immediately started discounting rate hikes. That was seen as positive for the US dollar index, which jumped from 90.50 to 92.40 levels within a week. The reason behind the fall in long-term yield is that Fed conveyed that long-term inflation expectation is going to converge towards their target of 2 percent levels rather than confirming that inflation will remain sticky for prolong period on account of demand-pull led growth.

“It is obvious that Fed cannot discount each and everything at one go”

The Fed has to wait for confirmation of the data but even a small twist in the tone and as seen over the last meet had led to a panic in the market. Now, the market is well-versed with the 2013-Taper Tantrum scenario—when just before the announcement of tapering, the long-term inflation expectations were hitting the 2.5 percent level and the 10-year yield was seen hovering near 1.5 percent with negative real rates. The market is currently dictating the 2013 story as yield is hovering near 1.35 percent and 5Y-5Y (5-year forward inflation from 5 years now) inflation expectation is quoting near 2.18 percent with negative rates.

However, just after the announcement in 2013, the bond yield rose sharply above 3 percent and inflation expectations settled down to 2 percent. And that caused real rates to come into positive territory. As real rates suggest some importance to the investment world and being the safest investment, the flight of capital was observed from Emerging markets to the US bond market. As other developed markets too were sending optimistic signals that time, the US Dollar index didn’t gain much against its peers. In 2021, it is clear that other Developed market central banks like BoE, ECB are not thinking about tapering or rate hike and thus US Dollar index will have an advantage over the two country’s yield spread.

The commendable point in favor of the US is their vaccination drive and reopening. On one side where many nations are again imposing some restrictions after the rise over Delta variant cases, the US is running strong on its path and activities have kicked off well. Moreover, Biden’s multi-trillion dollar fiscal plans will help them to grow exponentially. However, this will be an add-on to the fiscal deficit but the impact of the growth in the future will be much higher.

The tightening can be seen in the Overnight effective Fed fund rate. At the end of the June quarter, the volume in the Fed’s overnight reverse repurchase operation hit a record high of $992 billion, curbing the rates from falling into negative territory.

While the US is growing and Fed is on track of tightening, the PBoC is playing the smart game by reducing their Reserve Requirement Ratio (RRR) by 50 bps with effective from 15th July. Probably, that will assist base metal prices to extend another bullish leg and turn up the stalled inflation expectation wind. This might be the aim of PBOC to make Fed think twice before ‘thinking on tapering’.

Technical Replica of 2013:

As Fed is on the verge of repeating its Taper-2013, the US bond yield is also set to repeat its move like 2013. If we closely observe the 2013 move, one can say that the US 10 year yield was flirting near its 200-Day moving averages before posting a vertical move towards 3.00 percent levels. This time too, the 10-year yield is flirting near its 200-DMA.

Hence, we are expecting that it will bottom out near 1.15 percent-1.20 percent and head towards 3.00 percent target levels as fundamentals are repeating. Meanwhile, 1.75 percent and 2.20 percent could act as an immediate hurdle for the yield, but Fed could smoothen out the way for it by announcing an unwinding program in Jackson Hole meeting.
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The probability of odds of Fed’s tapering keeps on increasing as the US is having an absolute and relative advantage over both Developed and Emerging markets. The yield curve is flattening after the Fed’s higher revision of the dot plot, but an upbeat growth outlook and sustainable inflation rate could keep the convexity back into the yield curve and thus long-term rates too start picking up.

Overall, we are expecting that 2013-taper story to repeat in 2021, with higher chances of the announcement in August Jackson Hole or in December FOMC monetary policy. Thus, hold your heart to watch the 10-year yield back above 1.75 percent and 2.20 percent over the short term and 3.00 percent over the medium term. Along with this, real rates are likely to recover their path like 2013, and positives rates will call back investments in the US. Broadly, the US 10 year yield will remain dedicated to the US dollar index and it could strengthen again towards 93.50-94.30 levels. This will surely have savior impact on the emerging currencies and Fragile Five (Brazil, India, Indonesia, South Africa, and Turkey) could be back in the picture.

—Amit Pabari is the managing director of CR Forex Advisors. Views expressed are personal.

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