Could the Dollar Lose Support of US Treasury Yields?

US Treasury yields have traded in a tight range between 3.3% and 3.55%
since December. Such little movement has been extremely rare since the
middle of 2007 (the start of the financial crisis) when Treasury
yields embarked on a sharp move lower. Since then rates have been
fairly volatile, as we have moved in and out of a risk seeking
environment.

So could the calm in the bond markets actually be the calm before the
storm, and should we expect a large move in yields?
Right now a fall in yields seems more likely than a rise. Unemployment
remains stubbornly high and Friday's disappointing non-farm payrolls
figure suggests it will take many years for employment to pick up to
an extent that is acceptable to the Fed. This should keep a lid on
core inflation for the time being. Combined, this suggests that the
Fed will be loath to withdraw stimulus too soon and raise interest
rates.

Alternatively, a rise in yields could be precipitated by bond
investors turning their focus from Europe's periphery and
concentrating on the US's enormous (and growing) debt mountain - now
well above $14 trillion. However, this seems unlikely to us anytime
soon, though we wouldn't rule it out for the future.

There is a risk that weak inflation data due this Friday (core
inflation is expected to fall to 0.7% from 0.8% on an annualised basis
in December) may cause yields to fall dragging the dollar lower. The
correlation between the two asset classes has been extremely close
since the start of the year at 60%. The chart below shows 10-year
Treasury yields and the dollar index, which has been indexed to 100 to
show the two asset classes move together. As you can see they tend to
move in the same direction. So lower yields could precipitate a bout
of dollar weakness.

The dollar index (orange line) and 10-yr US Treasury yields
However, any fall in the dollar could be capped by weakness in the
euro. There is still a lot of downside risk for EURUSD [1]. The
sovereign debt crisis has caused a narrowing of the spread between
European 3-month deposit rates and US 3-month deposit rates since the
start of November, this coincided with EURUSD rising above 1.4000 and
since then the pair has been on a downward trajectory. Thus, while
this spread keeps narrowing it suggests further EURUSD weakness.
EURUSD (orange line) and euro/US dollar [2] 3-month deposit rate
spread:

Overall, watch out for short-term dollar weakness on Friday if we see
weak inflation data push down Treasury yields, but don't expect it
to last too long, especially against the euro.
Source: ActionForex.Com