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The Market That's "Ground Zero" for Deleveraging

The Market That's "Ground Zero" for Deleveraging

Kathy Lien, Technical Strategist

Steep increases in global bond yields require the full attention of FX traders as well as those in other markets because higher yields could quickly translate into risk aversion and panic on the part of investors.

The US dollar (USD) is starting the week stronger against all major currencies as deleveraging in the equity, bond, and currency markets continues to drive investors into the arms of the greenback.

The rush to liquidate out of dollar-funded carry trades along with renewed demand for long US dollar positions has driven the mighty buck sharply higher over the past week. The recent signals of policy actions (or the lack thereof) by the US and Chinese central banks have caused havoc within the financial markets.

Even though the Federal Reserve may feel that the US economy is ready for less stimulus, investors are worried that fewer asset purchases in the US and less liquidity in China will combine to slow the global recovery.

See related: This Summer’s Biggest Risk Factor

Despite the pullback in the SHIBOR rate, the 5.29% decline in the Shanghai Composite Index overnight dragged global equities lower with US stock futures pointing to a sharply weaker open. Unfortunately, there is no US data on the economic calendar today to reverse any slide in stocks.

Forex traders and those in other asset classes should keep a close eye on the bond market because it has become ground zero for deleveraging. US ten-year bond yields have broken above 2.6% today, rising another 11 basis points (bps) to the highest level since August 2011. With 3% yields in view, the cost of borrowing could soon reach levels that are overly oppressive for US consumers and businesses.

Unfortunately, US yields are not the only ones that have shot higher this morning. In Australia, ten-year bond yields jumped 27 bps, UK yields were up 14 bps, and German yields increased by 11 bps. In a growing economy where risk appetite is healthy, rising bond yields could represent strength, but in today's market environment, the rise in yields is a sign of panic.

In recent years, the Fed's ultra-loose monetary policy kept a lid on yields and made US-dollar-funded carry trades extremely attractive to global investors. However, that all changed last week when Fed Chairman Ben Bernanke said the Fed is ready to taper asset purchases this year and end them completely by mid-2014.

US bond yields soared on the heels of the announcement, stocks plummeted, and the dollar shot higher.

More: The (Big) Problem with a Stronger Dollar

Last week marked a major turning point for the greenback, and the uptrend is likely to continue in the coming weeks, albeit at a more moderate pace. The next step would be to initiate long dollar positions, which we expect to occur over the next few weeks.

Previously, the majority of market participants expected the Fed to taper next year, while just a minority was looking for this to occur in December. Now everyone has to rush to reset expectations and position for the strong possibility of Fed action in September, which adds to the potential for further US dollar gains.

In terms of technical levels, there is a significant EURUSD support level at 1.3075, where the 38.2% Fibonacci retracement of the July 2012-January 2013 rally converges with the 50-,100-, and 200-day simple moving averages (SMAs), which is being tested at the time of writing. If this level is broken in a meaningful way, the next EURUSD price target will be 1.30.

USDJPY, on the other hand, is crawling towards 100, but a move to 103 would require the Japanese to (finally) buy foreign bonds.

The selloff in AUDUSD is once again stalling at 0.9165, which is the 38.2% Fibonacci support of the 2008-2011 rally, which took the currency pair from 60 cents to 1.10. If this level breaks in a meaningful way, AUDUSD could quickly tumble to 90 cents.

See also: 3 Crucial US Dollar Price Levels

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.