Optimism about a possible U.S. economic recovery--and growing speculation the Fed is not preparing more stimulative bond-buying--has sent both U.S. Treasury bond yields and the dollar surging to multi-month highs. Although the greenback retrenched Friday after a trifecta of soft economic data, analysts believe the dollar's rally has further to run.
That conventional wisdom will face a test early next week, with New York Fed President William Dudley and Fed Chairman Ben Bernanke--both vocal proponents of ultra-accommodative monetary policy--scheduled to speak. Should either confirm the market's suspicions about holding off on more bond-buys, the dollar would be well supported.
But any hints of more stimulus would put downward pressure on Treasury yields and the dollar.
Scott Brown, chief economist at Raymond James & Associates, said a third round of quantitative easing, or QE3, "is still a possibility, but it's conditional on the economy weakening more." Brown noted a still weak housing market remains "a major disappointment for the Fed."
That disappointment gives added significance to a spate of U.S. housing figures next week. With rising bond yields dictating the dollar's moves in the near-term, weak data readings may spur new QE3 speculation and threaten the greenback's revival.
"With [U.S. Treasurys] perhaps mildly oversold, and Dudley and Bernanke unlikely to be less dovish, we anticipate the USD could sell off mildly as yields soften," analysts at Bank of America-Merrill Lynch wrote in a research note Friday.
By selling the dollar on weak data, traders would be increasing a new trend that marks a possible end to the "risk-on/risk-off" paradigm of the past few years. In the past, investors have used good U.S. figures as an impetus to sell the dollar in favor of higher-yielding currencies, but that trend broke down after the Fed's Tuesday meeting this week.
A sustained dollar rally on positive data "would be another indication that the market is moving exclusively away from risk-on/risk-off to something more complex," said Jonathan Lewis, chief investment officer at Samson Capital.
While the dollar has strengthened, the euro has been unable to pick up steam even as fears about a European debt crisis wane thanks to a completed massive debt restructuring for Greece.
Aside from economic fears about the 17-nation currency bloc, traders are also grappling with how the payout of Greek credit-default swaps will impact the market.
An auction of Greek CDS's will take place Monday to establish how much insurance-holders should be paid. A larger-than-expected payout could batter European bond markets, and trigger euro selling. Bond auctions in Portugal and Spain will also serve as barometers of investor sentiment toward the debt-strapped countries.
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