This week looms as a pivotal moment for the US rates and dollar outlook with 2-year US Treasury yields testing cyclical highs into a busy calendar laden with top-tier economic releases. Given the influence short-dated rate differentials play in determining FX valuations, whether 2-year yields can push higher will likely make-or-break the prospects for a sustained US dollar rally in the absence of a ‘Black swan’ event.
US 2-year yields testing fresh cyclical highs
The monthly chart below shows that after the rapid increase coming out of the pandemic, US 2-year yields have stalled above 5%, trying and failing on multiple occasions to sustain a push to fresh multi-decade highs.
Make-or-break week for the US dollar
While the economic backdrop appears vastly different compared to 16-years ago, the willingness of investors to purchase shorter-dated Treasuries above 5% is similar what was seen before the GFC. The question is whether that will continue? Because whatever the answer, it will have ramifications for a variety of asset classes, especially those priced in or against the US dollar.
Market is positioned for higher short-term yields
As pointed out by my colleague Matt Simpson, net short exposure in US 2-year note futures sits at the highest level on record, according to latest data from the CME Commitment of Traders’ (COT) report. While that does not mean short exposure can’t increase further, adding to upside risks for yields, it suggests expectations for US rates to remain ‘higher for longer’ is largely factored in. Markets are priced for a soft economic landing, characterised by ongoing labour market strength and the risk of inflationary pressures reemerging.
Path of least resistance for yields now lower?
But what will happen if the consensus view were to suddenly change? Predicting such outcomes is difficult but we may have received a small taste last week following the release of the S&P Global US composite flash PMI report for August.
Without passing comment on whether it’s justified, few will argue this report rarely receives attention, especially given the reliable historical track record of the rival Institute of Supply Management (ISM) PMI report. But on this occasion, it caused an unusually large market reaction after reporting softening activity at US private sector firms. US Treasury yields and dollar fell sharply on a release that’s usually ignored. While the moves were reversed quickly, it would have been interesting to see whether that would have occurred without Fed Chair Jerome Powell speaking less than 24 hours after.
It reinforces why this week could be crucial for the USD. 2-year yields are testing fresh highs, with record short interest, heading into non-farm payrolls and core PCE inflation. Based on price action and trader positioning, it appears the path of least resistance for shorter-dated yields may shifting from the upside to downside. That’s important for assets worldwide, especially those highly influenced by the US dollar and interest rate fluctuations. Commodities stand out, especially gold.
Gold worth watching
Even with the strengthening dollar and fresh cyclical peaks for US yields across several durations, gold prices hung tough earlier this month, repeatedly finding bids at the top of a demand zone located around $1,850/oz. More recently, probes below the 200-day MA have also been bought.
Given the resilient price action, any renewed declines in the US dollar and bond yields may act to push the gold back towards resistance located around $1885/oz. A break of that level could potentially open the way for a retest of the multiple multi-decade highs located above $2,050/oz. On the downside, minor resistance is found around $1,900/oz and $1,894/oz before the larger support zone kicks in.
Outside of bullion, currencies that have underperformed recently against the US dollar, such as the Japanese yen, Chinese yuan, Australia and New Zealand dollars, may also experience outsized moves to a recalibration of US interest rate expectations.
How to trade with City Index
You can trade with City Index by following these four easy steps: