MUFG’s Derek Halpenny notes the US Dollar (USD) is strengthening as US fixed income sells off, driving global bond weakness and higher yields across the curve. A poor 5-year UST auction and strong US and global PMIs are reinforcing hawkish Federal Reserve (Fed) rhetoric. Rising Brent Oil and potential US diesel export bans add to inflation risks, supporting the Dollar and threatening carry trades in a low FX volatility environment.

Dollar benefits from yield surge

“The US dollar has advanced further with the sell-off in US fixed income leading the way for global bond markets. A number of factors came together to reinforce the recent negative sentiment. The move has the hallmarks of a pain trade and forced selling by investors at these more elevated levels and could have further to run.”

“The worsening fixed income sentiment was reinforced by a poor 5-year UST bond auction yesterday. The USD 70bn worth of bonds sold at a yield of 5.033%, the highest level since June 2006. The bid-to-cover was 2.21, lower than the 6mth average of 2.33.”

“Both the Manufacturing and Services PMIs for September surged which will encourage the Fed to maintain the current hawkish rhetoric. The strength wasn’t US specific either with the data stronger than expected in Europe as well. The Global Composite PMI increased to 58.4 in September, the highest level since July 2021.”

“That leaves FX more vulnerable to a carry unwind given how well these trades have done in this incredible low FX vol environment. Periods of low FX volatility always end with a bang and current market conditions are certainly consistent with an increased risk of that scenario materialising. High yielders across EM would suffer most while the yen and Swiss franc would outperform.”