Euro-Dollar Slump Gathers Pace, Fall Below 1.20 Justified says Commerzbank

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The Euro-to-Dollar exchange rate (EUR/USD) has made a convincing break below the key 1.20 level driven by a surge in U.S. Dollar buying, after Fed Chair Powell failed to directly address a surge in U.S. bond yields.

U.S. Federal Reserve Chairman Jerome Powell appeared in a streamed Wall Street Journal interview where he made his final comments ahead of the Fed's March 17 policy meeting. (Fed board members enter a two-week communication black out period this weekend).

The event was Powell's final opportunity to address the surge in U.S. bond yields that have hit equity markets over the past week and sent the Dollar higher.

"He shied away from directly addressing the moves on the bond markets over the past weeks or to try and influence them directly," says Esther Reichelt, FX and EM Analyst at Commerzbank.

"That in itself was sufficient to cause a renewed rally of longer-term US yields, causing the dollar to appreciate sharply, with EUR-USD falling back into the area below 1.20," she says.

The market was expecting some strong guidance on what the Fed intends to do in order to address the rising yields on ten-year bonds that have been such a source of anxiety for investors.

Powell said he "would be concerned by disorderly conditions in markets or persistent tightening in financial conditions".

But, there was no explicit commitment to action.

Financial social media channels on Thursday incorrectly reported Powell would lay the ground for a 'twist' operation, whereby the Fed would start buying longer-dated bonds to keep them supported and suppress the rise in yield paid on those bonds.

"Investors were expecting him to talk the yield curve down more explicitly, and when such a message did not come, they started to sell bonds," says Michael Rottmann, Head Fixed Income Strategist at UniCredit Bank.

The rise in yields is at its heart a story of inflation expectations - investors are expecting higher inflation in coming months and years and they are dumping U.S. treasury bonds, particularly long dated bonds, as a result.

But this in turn pushes up the yield on those same bonds as investors demand more compensation for holding them in the face of detrimental inflation rates, which in turn raises the cost of finance for businesses and acts as a headwind to the recovery.

Understandably stock valuations are impacted negatively.

The 10-year U.S. Treasury yield broke above the 1.50% mark, posting another 6bp increase after the previous day’s 10bp rise.

For foreign investors however the relative rise in U.S. yields is attractive, which in turn sees the Dollar bid higher on capital inflows.

The Euro-to-Dollar exchange rate has broken below 1.20 and is at 1.1957 ahead of the weekend.

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Should the sell-off in bonds and the rise in yields continue then the Dollar will likely find further support and stock markets will likely extend their recent sell-off.

Powell said full employment was some way off and as a result any rise in the rate of inflation over the coming months would be temporary.

However, "if inflation risks overshooting the Fed’s 2% target significantly and on a sustainable basis the Fed is going to find it increasingly difficult to invalidate the normalisation speculation even if the labor market is not yet satisfactory," says Reichelt.

Commerzbank's economists expect the U.S. growth boom to be relatively short-lived and that it will be unable to drive inflation upward on a sustainable basis.

"As soon as that becomes clear the USD bulls are likely to become more cautious again. This will take a while though, as a result EUR/USD levels below 1.20 are justified for now," says Reichelt.