(Bloomberg) -- Dollar bulls looking for a breakout are finally finding support from U.S. interest rates as Treasury yields climb toward levels unseen since 2014.
The greenback set a three-month high Monday as 10-year yields rose to within a whisker of 3 percent, a key mark that some observers see as potentially opening the door to much higher levels. The two markets are moving more in sync after the relationship cooled for a spell: The 60-day correlation between the Bloomberg Dollar Spot Index and 10-year yields has turned positive, after dipping into negative territory in recent months for the first time since 2016.
The shift is welcome news for investors wagering on a dollar rebound. Eurizon SLJ Capital Chief Executive Officer Stephen Jen expects the dollar to recover against currencies such as the euro this quarter, given that he no longer considers the greenback overvalued and views U.S. economic fundamentals as remaining robust.
“Yields are very important,” said Jen, a former economist at the International Monetary Fund, World Bank and Federal Reserve. “Just because the 10-year is drifting higher doesn’t necessarily mean the dollar can rally, but I do think at this point we have a situation where the dollar can be well supported.”
Jen expects the dollar to appreciate to $1.17 per euro this quarter, from about $1.22 now. Europe’s shared currency is coming off a five-quarter rally.
Though a global economic recovery has boosted the euro against the greenback, Europe’s growth rate is poised to decelerate, according to Jen. A report showing the euro area’s composite Purchasing Managers’ Index was unchanged for April signaled that growth in the region is set to continue, albeit at a slower pace.
Market positioning suggests traders may not be ready for that scenario. Hedge funds and other large speculators hold a record net long position in the euro, Commodity Futures Trading Commission data show.
Those investors are set up for a “pain trade” should the dollar recover, said Ugo Lancioni, head of global currency at Neuberger Berman Group LLC. He expects that the dollar will rebound by 2 to 3 percent this quarter.
“That wouldn’t be a crazy move, but it’s a move investors probably aren’t prepared to digest right now,” said Lancioni, who helps oversee $299 billion. “My gut feeling is that many people jumped on this dollar short a bit late.”
Lancioni foresees greenback gains as higher U.S. yields attract capital. Similar to Jen, Lancioni expects dollar strength to be best expressed against the euro, with the yield gap between U.S. and German short-end rates favoring the dollar.
The U.S. two-year rate was at 2.48 percent as of 7:40 a.m. Tuesday in New York, compared with about minus 0.55 percent for similar-maturity German debt.
And then there’s the added wrinkle of trade tensions, which strengthens Jen’s conviction that the dollar is set to appreciate mainly against the euro.
China and other Asian nations will likely be reluctant to let their currencies depreciate, given the Trump administration’s renewed focus on foreign-exchange manipulation, according to Jen.
“You have this added angle of politics,” he said. “It’s really polluting the economic angle, but if you think about interest rates in the U.S. and the soft patch in the European recovery, it makes the euro-dollar cross more clear.”
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