USD and 10-year yield higher in anticipation of the FOMC

• DXY inching higher, testing resistance near 91.97.

• 10-year UST breaking into 1.60% territory.

• Questions about inflation outlook, potential yield curve control expected.

With a number of central bank meetings taking place, including the BoE and the BoJ, the Fed’s statements are the most anticipated.

The Fed, with its dual mandate of ensuring price stability and a full employment, is undoubtedly in a conundrum. Inflation expectations are at a 7-year high with the Treasury 10-year breakeven rate at 2.30%.

Economists forecast Q2 annualized inflation to reach as high as 2.9%, and stabilizing at 2.2% next year. U.S. economic growth is now projected to reach 6% this year. Although the Chair Jay Powell has previously calmed the public by committing to low rates until 2024, or until the labor market and inflation criteria are met, the markets disagree. Bond markets have started repricing the updated inflation and economic outlook, with Treasury yields at 13-month high, and yield curve steepening to a 5-year high.

Treasury 10-year yield, the proxy of risk-free interest rate, is attempting to establish a new floor at 13-month highs, near 1.60%. Higher risk-free rate has been stirring other asset classes, causing headwinds for risky assets and tailwinds for the dollar. Yields have an inverse relationship with the bond price, hence the selloff in bonds can be interpreted as inflation expectations and economic recovery being priced into instruments that have finite cash flows from coupon and principal payments.

The Fed is not directly determining the 10-year yield at this point - a market operation called yield curve control. However, the Fed does have an impact on bond prices through its asset purchases program. By buying Treasury bills and notes, the Fed is acting as an indiscriminate buyer to provide monetary stimulus, supporting the prices and suppressing the yields.

Should the Fed determine that the current 10-year 1.60% yield is having an adverse effect on other markets, we might see another round of Operation Twist, or targeted purchases of Treasuries with different maturities. The aim of such an operation is shaping the yield curve – bringing the 10-year yield lower by purchasing more Treasuries with a weighted average maturity of 10-years.

The dollar has been bolstered by relatively higher U.S. rates, with global investors seeking higher rate of return from the world’s most liquid and deepest market. USD, measured by DXY, has been in an upward trajectory since early March when short-term moving averages turned bullish. After breaking the resistance level near 91.0 and testing 4-month high of 92.50, the price pulled back to 8-day exponential moving average level (EMA) and continues to consolidate near 91.85 level.

Support levels have formed near 91.72 and 91.66, while resistance levels have formed near 91.97 and 92.03. RSI and slow stochastic are both neutral but DMI+ of 26.3 dominating DMI- of 14.7 signals bullish trend. Albeit with little conviction with ADX currently near 25.7. Technical indicators support DXY bullishness on the daily chart, while weekly requires more convincing that the dollar has got the momentum to break higher.

The market is not expecting the Fed to change their dovish tone and will most likely maintain their current projections about economic outlook, whilst potentially commenting on inflation flare up and 10-year yield. Should the Fed continue to pursue its current dovish tone and hold economic projections largely the same, we foresee DXY consolidating near current levels of 91.8. Comments about inflation expectations, yield curve control and employment projections have the potential to move the markets and cause volatility.