Traders Are Looking for Higher Yields

09/23/2008 12:00 am EST

Focus: FOREX

John Jagerson

Co-Founder and Contributor,

I am a little skeptical that the recent run back down on the USD has legs in the long term. Not just because the capital markets are in disarray so we have to expect some volatility, but there also appears to be some indications that traders are expecting a return to higher yields in the US in the near term. Specifically, I am watching the yield index on the 10-year treasury note. The yield index is rising very quickly, which typically happens as traders start to anticipate an increase in bond yields in the near term. This is often a very bullish signal and could strengthen the USD in the short term.

I think that forecast is in line with the underlying market fundamentals right now. There is a lot of buzz in the media that banks and companies are just not willing to loan money to each other. This creates a crisis because many companies (if not most) rely on credit facilities to operate their businesses. However, it is not that loans are not available, it is that loans are not available at interest rates that the Fed considers desirable. The Fed funds rate right now is targeted at 2%, and to keep it at 2%, the central bank is having to make massive loans to the capital markets in the form of short-term repurchase agreements, loan guarantees, and bailouts. I think that the Fed is going to have a hard time prevailing against fundamental forces that want higher yields to compensate for the new market risk environment.

History shows that market interventions that are designed to fight changes in the risk environment usually fail. That means that if the market wins and higher yields materialize, we could see a resurgence in the value of the USD. If this is accompanied by more confidence in the capital markets, it could also turn the tide on the JPY and push values back down there as well.

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