While higher yields in bonds make them more attractive to investors, the bond market turmoil could also be a sign of a growing disenchantment among foreign investors with U.S. assets - with worrisome consequences for the greenback.
"While the dollar has survived and even benefited from the higher yields associated with lower Treasury prices, we seriously doubt it would be able to withstand large losses in U.S. financial assets more broadly (i.e. stocks and bonds)," said Robert Lynch, currency strategist at HSBC in New York.
As to the market's conviction that there will be no Fed rate cuts this year - with some even pondering the possibility of a hike - recent comments by Fed Chairman Ben Bernanke could easily be interpreted to suggest that cuts are still in the realm of the possible.
Yes, Bernanke said inflation is still a risk and said economic growth would rise moderately, which does not suggest conditions for rate cuts. But in nearly the same breath, he also said housing - perhaps the economy's main problem - will be weaker than previously thought and said core inflation is ebbing. This could brew up a perfect storm for rate cuts, and housing market lobbyists may very well start clamoring for them.
Dollar Gains Twice From Lower Odds Of Rate Cuts
For sure, there's more than higher bond yields backing the dollar's recent gains. The dollar had already begun to rise in early May, long before the bond market ran into a wall of selling. Throughout May, the dollar was inching higher with each better-than-expected U.S. economic report on everything from hiring and manufacturing to inflation and trade.
This improved data slowly shifted currency analysts away from their expectations that the Fed would cut interest rates this year to kick-start the economy.
U.S. bond markets were slower to catch on to the data shift - not until last week did they add it up and in dramatic fashion price out the odds of any 2007 Fed rate cut, pushing yields on the 10-year Treasury note to as high as 5.31%, a five-year high.
The drama caused by the surge in bond yields spooked U.S. stock markets, resulting in the sharpest pullback in equities during the past three months.
Amid soaring rates, the dollar's rally got a second lease of life, confounding those who had been calling for a reversal in the greenback's fortunes. Wednesday, it reached a fresh two-month high against the euro, at $1.3264, and a five-year high against the yen, at Y122.48.
Contrast that with late April, when the euro hit a record high of $1.3682 - and analysts were forecasting a run to $1.40.
Suddenly, $1.30 seems more likely - but don't bet on it.
Homeowners Hate Higher Yields
Even as economists on Wall Street are pushing out rate cut expectations into 2008, contrarians such as Mark Meadows, currency strategist at Tempus Consulting in Washington, continue to maintain that cuts are possible this year - given the challenges the U.S. consumer is facing.
"The strength of the U.S. economy has continued to depend on the consumer, who has remained resilient despite falling home prices (and) high oil prices," he said in a research note.
But, he added: "Because of these (and other) mounting pressures, it becomes a question of when, and not necessarily if, the U.S. consumer will begin to react negatively to these factors."
The rise in market rates could also end up hurting the consumer - as the 10-year Treasury yield is the benchmark rate for fixed-rate mortgages, while mortgages with adjustable rates are tied to a broader range of market rates.
And with the housing market clearly still struggling - home foreclosures in May jumped 19%, according to RealtyTrac, an online marketplace for foreclosed properties - rising mortgage rates will hurt even more.
"At the end of day, higher bond yields will undermine the housing market," said Hans Redeker, head of global foreign exchange strategy at BNP Paribas in London. "If you're are a homeowner who is stressed out and looking to refinance, you will hate these higher bond yields."
It's Still About Housing
Bernanke's warnings last week that the housing market is still in pretty deep trouble serves to underline that view.
His comments on housing, combined with soothing words on inflation, indicates for Tempus Consulting's Meadows, for one, that there's room for an ease if the consumer starts to wobble seriously. He dismisses the continued inflation warnings as routine tough talking from central banks.
After all, lower interest rates, a potential cure for many economic maladies, are the quintessential solution to a housing slump.
And if the Fed does cut rates in 2007, you can bet that the $1.40 for the euro could be reached after all.
(Dan Molinski covers foreign exchange markets for Dow Jones Newswires in New York. He was previously a correspondent for Dow Jones in Bogota.)
-By Dan Molinski
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