It's not every day that the U.S. dollar breaks away from its safe-haven reputation. Allow me to show you how the past couple of days have been perfect examples showing the Treasury bond yields-U.S. dollar correlation.
For the newbies out there, here's a crash course on U.S. Treasury Bonds.
What are Treasury Bonds?
As you've learned in the School of Pipsology lesson discussing the 411 on bonds, a bond is an "IOU" issued by an entity when it needs to borrow money. In particular, a Treasury bond is issued by the U.S. Treasury Department when it needs funds to finance its operations.
In return, holders of the bonds will earn interest on their loaned funds based on the prevailing interest rates. This amount of money earned from holding Treasury bonds is called the Treasury yield. Still with me? All right then, let's move on.
Treasury yields are typically influenced by demand for the bonds. If not a lot of people are buying Treasury bonds, then yields usually increase to attract investors. But when there is high demand for these US-backed IOUs, then yields usually go down.
The U.S. 10-year Treasury bond yield spiked to a high of 2.276% this week, its highest level since October last year. However, demand is still at near historic lows. How did that happen?
Treasury Yields and the Stock Market
Bear in mind that Treasury yields also serve as an indicator of the strength of the U.S. stock market. When Treasury yields are dropping, this usually means that investors are moving their money out of low-yielding investments to riskier ones such as stocks. With that, rising Treasury yields typically reflect stronger performance of the U.S. stock market.
Lately, there have been a lot of factors spurring risk appetite and pushing investors to buy more U.S. stocks. For one thing, improvements in the U.S. economy such as the better than expected non-farm payrolls report and the upticks in manufacturing PMIs encouraged market participants to take on more risk. On top of that, the approval of Greece's second bailout package eliminated some of the uncertainty looming over the markets.
With that, the Dow Jones Industrial Average zoomed to its highest levels since 2007 this week while the Nasdaq Composite Index jumped above the 3,000 mark for the first time since 2000. I'm pretty sure that's not just a result of the unveiling of the new iPad!
Of course this surge in demand for U.S. stocks suggests a higher demand for the U.S. dollar which is the currency used to pay for these assets.
Treasury Yields and Interest Rate Expectations
Treasury bond yields can also serve as a good indicator of interest rate speculations. Since Treasuries are basically U.S. government bonds, higher interest rates from the Fed will also push treasury yields higher.
This is probably why the Fed's latest monetary policy statement is causing such a ruckus on U.S. Treasury yields. A month ago, weak economic data from the U.S. led investors to believe that the Fed will soon pull the trigger on another quantitative easing program to boost the economy.
But with economic engines in the U.S. showing improvement, the Fed adopted a not-so-dovish stance in its latest monetary policy announcement. The Fed recognized the progress in the economy and said that QE3 should be a last resort.
A QE3 might not be completely off the table, but I guess it's enough for market players! Today, not only are investors not expecting a QE3 in the near future, but there have also been speculations that the Fed will INCREASE its interest rates earlier than expected!
Some say that the dollar's correlation with the 10-year Treasury yields won't last as the dollar will soon return to its safe-haven role. But now that you know how the dollar can react to price action in Treasury bond yields, there's no way you shouldn't take advantage of the current trend!
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