DXY Pauses as ’Normal’ Trading Resumes; EUR/USD in Focus
- Yield-risk relationship is starting to normalize: when yields go up, so does the US Dollar; but down go equities.
- See our weekly data preview for outlooks on the remaining key data this week.
Markets are starting to behave normally again, where higher yields and strength in the local currency leads to a weaker local equity market (and vice-versa). We're on the other side of this spectrum today, where softness in US yields has led to the US Dollar (via DXY Index) pausing around its highs from the past near-two-year range. Concurrently, US equity futures are gently nudging higher.
This subtle yet important shift in the underlying relationship of the market suggests that investors have started to move away from the "buy everything" mindset. In years past, with central banks flooding the market with liquidity and buying excessive amounts of government debt, bond prices have risen rapidly alongside higher equity valuations. Yet over the past week, this has turned on its head now that the prospect of Fed rate hikes down the line looks sincere with President-elect Trump's stimulus plans.
Underpinning all of this is the evolution of the equity risk premium, the excess return that investing in equities over risk-free government debt provides. With US Treasury yields rising sharply in such a short period of time, the ERP has started to shrink rapidly, reducing the appeal for risk taking. As long as US yields remain elevated off of their pre-election floor, then we should expect to continue to see the normalization of the yield-risk relationship (in other words, throw away the QE-era playbook that higher US yields and higher equity markets will go hand-in-hand).
Elsewhere, it's time to put EUR/USD into focus. The big picture: it's in the midst of an historic streak of price consolidation, but it appears to be coming to an end. Likewise, as discussed in the video, the recent move lower in EUR/USD hints at a potentially significant move to come lower in the pair. Read our Q4'16 forecast, "EUR/USD Coil Grows Tighter as Central Banks, Politicians Face Credibility Deficit."
--- Written by Christopher Vecchio, Senior Currency Strategist
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