U.S. Dollar Correction Underway as Oil, Bond Yields Fall Back

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The Dollar has fallen against the Pound, Euro and most other major currencies and analysts say this correction can extend if global bond yields and oil prices fall back further.

The selloff in long-dated global bonds has been the market's main concern over recent weeks - the resultant rising yields being a key driver of Dollar strength - but the move looked to be overextended heading into October and vulnerable to a correction.

The catalyst to the correction in bond markets appears to be the sudden slump in oil prices back below $90/barrel which has offered some relief to investors fearing a fresh inflationary episode was building momentum.

"An oversold market started looking for a floor. A crash in the oil price did the trick from European noon, triggering investors to square some positions after a breath-taking sell-off which started this summer and accelerated after the September FOMC meeting," says Mathias Van der Jeugt, an analyst at KBC Bank in Brussels.

Recovering bond markets resulted in falling yields, which eased financial conditions and boosted demand for stocks, creating a 'risk-on' environment for currencies such as the Pound and Euro to stage a recovery against the Dollar.

The fall in oil has an impact too: "The USD link to oil has flipped from a highly negative correlation into the 2008 crisis to a slightly positive one now. Higher energy prices help the US and that matters today given the $5 drop over the last 24 hours and the implications for inflation, rates and global FX," says Bob Savage, Head of Markets Strategy and Insights at BNY Mellon.

The Pound to Dollar exchange rate rallied nearly half a per cent in midweek trade to go back above 1.21 to close at 1.2133, where we find it at the time of writing Thursday and suggests our week ahead forecast for a correction higher is playing out. The Euro to Dollar pair has meanwhile recovered to just above the 1.05 level.

The Dollar index - a measure of broader USD performance - has pared back its advance from Tuesday's peak at 107.34 to quote near 106.73.

"The dollar correction is modest so far (trade-weighted from 107.06 open to 106.80 close) but continues this morning," says Van der Jeugt.

Rising oil prices were part of a financial market cocktail that was supportive of a rising Dollar and what happens here can determine how far the Dollar correction can extend.

Brent crude prices tumbled from a start above $91/b to $86/b, their lowest level since the end of August.

Above: The Dollar index (top) is tracking U.S. ten-year bond yields which eased back after the bond selloff was paused.

KBC Bank says the move was partly technically related after a drop below the $90.5/b neckline of a double-top formation. According to one analysis, crude oil's u-turn could put it on track for a downside test of $75 a barrel as "concerns over a slowing global economy triggered heavy sell orders that overwhelmed intraday rallies," says Alex Kuptsikevich, senior market analyst at FxPro.

"The Saudi/Russian additional oil production cut confirmation until December, failed to bring counterweight. The oil market is looking for more of an equilibrium as well with $90+ levels being perhaps too optimistic over future demand despite restricted supply," says Van der Jeugt.

After yesterday’s move, KBC Bank believes the bearish momentum in bond markets can be put on hold for some time with "consolidation kicking in" and allowing for a rebound on stock markets and further USD weakness.

This would be confirmed if Friday's U.S. non-farm payrolls report shows signs of a weakening labour market; "the consensus bar (+170k) seems on the high end," says Van der Jeugt.

Ahead of the jobs report, a warning comes from Francesco Pesole, FX Strategist at ING Bank, that there is a risk that the breather in bonds and the dollar correction are too reliant on expectations of a jobs data miss.

"In FX, any tentative dollar correction is not finding too many followers. The swing in rate advantage after the recent bond sell-off makes the dollar a very hard sell, and cautious trading ahead of US payrolls tomorrow shouldn't help," says Pesole.

ING sees room for a 'hawkish' repricing of short-term U.S. bond yields "and the dollar’s upside risks remain substantial."