The last two trading days of the previous month brought a sharp reversal higher in the U.S. dollar. The dollar was sold across the board during the pandemic and at the start of the new trading year, but that came at an abrupt end last week. 

The reason for the reversal is attributed to the sharp rise in the U.S. 10y yield. It broke above 1.45% last week and the move higher brought an end to risk-on. More precisely, emerging markets got hit, the CHF and JPY got stronger, and the dollar as well. Furthermore, the reflation theme, so popular last December, is at threat of unwinding faster than the market expects. Therefore, the dollar’s recent move higher may be just the start of a new trend that goes against the main market’s narrative for the year.

Reflation Theme Unwinding?

Whenever long-term yields are rising, they bring together a tightening of financial conditions. If the rise happens during an economic crisis, when major central banks are in easing mode, things become complicated.

You may wonder what the EURCH chart above has to do with the rise in the U.S. 10y yield? The answer lies in the effect of higher yields across financial markets, as they unwind a risk-on environment. In such an environment, the CHF declines, together with the JPY – just as we saw recently with the USDJPY and EURJPY pairs rising, while the EURCHF moved higher as well. However, rising yields would cause the opposite, posing a threat to traditional risk-on moves.

Higher yields will also push the hand of the European Central Bank (ECB) to do some more. As such, the Euro is vulnerable against the dollar but also against the JPY, should the yields remain elevated.

What we can say at the start of the new trading month is that the higher yields led to a higher dollar. Also, if other central banks will react and ease some more (e.g., RBA, ECB), the Fed is unlikely to do so in the period ahead. Moreover, inflation will force the Fed to sit tight, further fueling the race to the dollar.

Last week we saw the Fed’s Chair delivering the semi-annual testimony in front of the Senate and the House. The markets feared a tapering of the asset purchases, and they were resting assured that is not the case. However, an equally problematic dollar tantrum may have similar consequences for financial markets as general conditions tighten with the rising yields.