What's Up With US Treasury Yields, and How Will That Affect USD/JPY?

by Nick Nasad

Wednesday's main theme and the reason we saw the USD higher during the session was a rise in Treausry yields. In fact if we look at the 2-year, 10-year and 30-year Treasury yields we see a strong surge in the past 2 sessions.

A 6-Month View of Treasuries

Here's a look at 2-Year, 10-Year and 30-Year Treasuries over the past 6 months. Among them all we see yields rallying, and especially strong in today's session.

2-year Treasury yields jumped above 0.60, surging in the last two session. The shorter-term 2-Year Treasuries are most important to the USD/JPY which we will look at further in this article. Safe to safe, after our bottom at the start of November, we had some ranging action, and now we surge higher to the highest in about 5 months.

10-Year Treasuries are at 6 month highs, as they shot above the 3% level this week.

30-Year Treasury yields rose to 4.5%. Here we see a bottom at 3.50% back in late August.

Tax Cut Deal at the Center of Recent Moves

Now, there are several reasons why yields are surging, and there are differences among shorter-term yields and longer-term ones, so lets go through some of these factors, and then move onto what it means for the USD in currency markets.

First off, we had President Obama and Republicans come to a tentative deal on Bush-era tax cuts this week. . The tax cut deal, not only extends tax cuts for middle class and the top 2% Americans, but also includes a $120 billion payroll tax cut, a $56 billion extension of unemployment benefits, as well as extending some other stimulus measures from the original Stimulus plan.

There are two forces working on investor expectations following this deal:

1. The tax cut extension is a growth positive development for the US and should help support consumption in 1Q and 2Q as well as help lift stocks. It also means that the pressure is lifted a bit on the Fed to have to signal that they are willing to undertake more bond purchases beyond "QE2″.

This development therefore could be interpreted as a sign that investors would rather sell Treasuries and snap up other assets as they see growth a bit stronger than expected. This factor would impact short term rates more so than longer term rates.

2. A second major factor is that the extension of tax cuts means that the US government will be adding on more debt to its already swelled budget deficit, and that could have long term implications for US fiscal health. Now, we did have Moody's say that the tax cuts would not change the outlook on the US Aaa credit rating (Moody's Says Tax Rates Won't Lead to U.S. Downgrade), but the proof is in the pudding as US Treasurys are being dumped and yields on 30-year and 10-year rising.

3. We also have lots of back and forth activity in the market due to the relentless pace of bond auctions from the US government. Today the Treasury Department sold $21 billion in 10-year notes at a yield of 3.34%, the highest since May. Demand was underwhelming with a bid-to-offer ration of 2.92, compared to an average of 3.13 the past four comparable sales.

Which factor is really behind the jump in yields? Is it optimism about US growth and the stock market, or is it a concern that the US is sliding down the same slippery slope we saw in Euro-zone. While you can't compare Greece and Ireland to the United States, the US faces similar debt and deficit worries.

We saw in the case of the Euro that surging yields shows a lack of confidence in those periphery bond markets, and the Euro fell sharply as a result. So far, the USD has gained as a result of its higher yields, a sign that investors may be giving the US and the USD the "benefit of the doubt."

The Pair to Follow in Regard to Yields is USD/JPY

Treasury yields, especially the short-term kind have a big impact on the USD/JPY. We know that in this pair risk-averse Japanese investors, which favor safer investments like government bonds are looking closely at yields when making their decision to buy US or Japanese government bonds.

As we can see the pair found a bottom in early November and since then has rallied rather strongly. That has coincided with our rally in yields that we see in our above charts. As US yields rose and made US assets more attractive, we have seen a move higher in USD/JPY.

Will this move continue? We run up against a very important support at 84.40 and retraced 50% of our most November upswing. We now come close to testing that resistance yet again. If this level is cracked we look to test the highs post BOJ intervention (large rally at the beginning of chart on Sept. 15th) around the 86 area.

If we continue to see US yields climbing – whether its on short term optimism in US economy or stocks, or because we see a further sell-off in US bonds in general, then that outlook becomes more probable.