Dollar Rises as Bond Yields Hit 10-Month High
US stocks dropped for the third day in a row, adding pressure on carry trades. Interestingly enough the US dollar rebounded strongly today as 10-year yields shot to a 10-month high above 5 percent. Traditionally when stock prices fall, bond prices rise (yields fall) as investors rush to safety of bonds. Today however both stocks and bond prices fell in tandem which only happens when the market needs to reprice rate hike expectations. This is the first time in almost a year that the entire yield curve is normalized and above 5 percent. Federal Reserve officials refuse to downgrade their degree of hawkish which is nothing new. What triggered the latest move in the markets was actually the jump in oil prices. Refinery shutdowns and a cyclone in the Middle East sent oil prices to a 9 month high today. With inflation creeping back into the picture, there is now a next to zero chance that the Federal Reserve will be cutting interest rates this year. In fact, the futures curve is pricing in a greater chance of a rate hike than a rate cut at this point. In a yield seeking world, higher rates or at least the prospect that rates will remain unchanged is of course positive for the dollar.

The stock market however does not like higher interest rates because it hurts corporate profitability. So keep watching the Dow as it will continue to be the biggest driver of price action in the currency market. As for data, jobless claims continued to remain low while wholesale inventories dropped slightly. The trade balance is due for release tomorrow. We expect the weak dollar to help reduce the trade deficit by more than the 0.3B improvement that the market is currently looking for.

Strong Swiss Employment Data Paves the Way for Rate Hike Next Week
The Euro continued to sell-off after traders adjust their expectations of when the European Central Bank will deliver their next rate hike. The disappearance of the words vigilance suggests that we will not see 4.25 percent rates until September at the earliest. There was no European economic data released today, but tomorrow we are expecting the German trade balance, current account and industrial production. The market is looking for very hot industrial production numbers but given the mixed factory orders report, there is a strong chance that the data could miss expectations. As for trade, if the strong Euro was going to have any impact on the economy, it would be in exports and imports. In the month of April, the EUR/USD surged from 1.3325 to an all-time high of 1.3682. Meanwhile Swiss unemployment fell to the lowest level in 4 years. The drop from 2.9 to 2.7 percent is a continual testament to the strength of the Swiss economy. The central bank will be meeting to discuss monetary policy next week and we expect interest rates to be lifted.

British Pound Collapses after Interest Rates Are Left Unchanged at 5.50 Percent
The British pound is the day’s worst performing currency. It is down 150 pips against the US dollar and 200 pips against the Japanese Yen. The Bank of England left interest rates unchanged at 5.50 percent, which was right in line with expectations. The sell-off began right at the European open and exacerbated after the interest rate decision despite the fact that the BoE does not make comments or release a statement when monetary policy is not altered. With the futures curve pricing in one and possibly even two rate hikes by the end of the year, some traders were clearly holding out for a surprise move. The only UK data released this morning was house prices, which grew less than expected in the month of May. Industrial production is due for release tomorrow. The weaker manufacturing PMI numbers suggest that overall production growth
was weak in April.

Dow Continues to Fall Taking Yen Crosses down with It
The Japanese Yen is stronger across the board for no reason other than the panic selling in US stocks. There was no economic data released last night and machinery orders are the only piece of data due for release this evening. We continue to stress that the Yen crosses will take its cue from the movements in US stocks. Although the Shanghai index rebounded on Thursday morning, the sharp sell-off in the Dow today could prompt a reversal in Chinese stocks. Risk aversion is rising and carry trades are the primary victims. Further losses are very likely, but we will probably not see major losses as many central banks are still on track to raise interest rates this year. The Bank of Japan on the other hand has no reason to alter rates as the strength of the yen will automatically tighten their economy.

Commodity Currencies Fell Victim to the Liquidation of High Yielders
Even the commodity currencies could not hold up against the liquidation of high yielding currencies today. Both the Australian and New Zealand dollars hit fresh decade highs before turning around to the end the day weaker against the US dollar. The kiwi fell the most despite an interest rate hike by the central bank yesterday. The statement was hawkish and the futures curve is pricing in more rate hikes this year which indicates that the liquidation is clearly just a reflection of rising risk aversion. The Australian dollar held up far better although it too saw major intraday losses thanks to strong employment numbers. After seeing very strong job growth in April, Australian companies added 39k people onto their payrolls in the month of May. This brought the unemployment rate down to a 4.2 percent, which is a new 32 year low. The Canadian dollar also dropped despite the rise in oil. There was no Canadian data released this morning, which suggests that the traders may be looking for softer employment and trade figures tomorrow. April data has been weak and the strong CAD could have put a big dent in exports.

Kathy Lien is the Chief Currency Strategist at FXCM.