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Dollar/Yen Sensitive to Interest Rate Movement

By Marc Chandler of BBH FX Strategy

NEW YORK ( TheStreet)-On the heels of the healthy March jobs report and new cyclical highs for the manufacturing and service sector ISM surveys, the market moved to fully discount a 25 bp rate hike at the November Federal Open Market Committee (FOMC) meeting. This was evident in the Fed funds futures strip and the OIS/Fed funds rate. The market has backed off slightly today.

U.S. interest rates have eased today, with coupon yields slipping 3-5 bp, perhaps on some bargain hunting after the 10-year yield reached 4% yesterday. Perhaps U.S. debt is also picking up a safe haven bid, given the blow out of Greek credits today.

Nevertheless, there has been a sharp backing up of U.S. interest rates in recent weeks. There are two components to interest rates. There are the real rates and the inflation premium. In some ways the inflation premium is easier to estimate and the residual would be the real rate.

One estimate of the inflation premium could be derived from the 5-year/5-year forward. Both the Fed and ECB have in the past cited this as one of the measures it looks at for inflation expectations. In the U.S. this rate is now about 2.58%. This represents a little less than a 20 bp increase since late February, which was the low point thus far this year. However, that increase seems to be simply noise as the 100-day moving average is near 2.63%. The recent high was set in early February just above 2.8%.

By contrast, the U.S. 10-year yield now at 3.94% is well above its 100-day moving average or 3.45%. It appears that the bulk of the increase in nominal U.S. interest rates reflects an increase in real rates rather than the inflation premium. Two considerations seem behind the rise in real yields--supply and stronger growth--and it is difficult to estimate the relative importance of each of these considerations. Subjectively, it would seem like supply is playing a bigger role than increased demand for investment capital.
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