Less Dovish Fed Sends Yields, Dollar Higher

NEW YORK ( BBH FX Strategy) -- The U.S. dollar is trading broadly higher in response to the less dovish Fed. The yen is the exception.

The rise in U.S. Treasury yields has led to a shakeout of positioning, with stocks declining. The FOMC minutes underscored that further policy easing would require a loss of economic momentum or a sharp drop in inflation. It appears to be a less dovish message than that delivered by Bernanke in last week's speech. On the growth outlook, the committee's views were more upbeat, as the Fed staff upgraded its near-term forecasts "a little."

Yet most members did not interpret the recent developments as a catalyst to upgrade their 2013-to-2014 outlook. Furthermore, the FOMC staff trimmed its estimate of the level of the potential output gap. This suggests that the FOMC estimates a lower level of "slack" in the economy. However, the minutes showed that significant downside risks to economic activity persist even though the strains in the financial markets have eased since January.
The Federal Reserve

The Fed also cited other risks to the economic outlook, including fiscal tightening, Europe-related risk, a slower recovery of the housing market, and deleveraging. In short, while the minutes show that the Fed is comfortable with its current policy stance and future rate guidance, it continues to reinforce our view that there will be no QE3 in Q2.

The European Central Bank has much to chew on Wednesday and it should be more evident in the press conference than the statement, which is no doubt going to leave rates unchanged.

The eurozone March purchasing managers' index remains below the 50 boom/bust level. Unlike the manufacturing PMI, the service measure was a bit better than the flash reading at 49.2 compared with 48.7 and it is even slightly better than the 48.8 in February.

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The stabilization of the regional economy that the ECB had pointed to appears at risk and the data is consistent with a further contraction of the eurozone economy in Q1. While the German reading of 52.1 is an improvement over the flash 51.0 reading, it is still down from 52.8 in February. Moreover, the German service sector is under-developed compared to its manufacturing sector and this has been a source of criticism from the European Commission. Germany, like other countries, is reluctant to restructure. However, the weaker-than-expected factory orders warn that even German manufacturing has lost momentum.

The ECB will also be aware of the backing up of European interest rates. Part of the increase was driven by the rise of U.S. yields, dragging other bond markets with it, but part of the increase is also the resurfacing of pressures in the periphery. Not only has the Greek PSI not brought closure, but the EC Commissioner Olli Rhen acknowledged the European Union may need to provide a "bridge" to help Portugal return to the market.

Pressure continues to build on Spain, where the first bond sale since it released its budget was a notable disappointment and Spanish equities continued to be trounced. The ECB has halted its sovereign bond and covered bond purchases. Under what conditions will they resume?

In contrast, the UK completed its trifecta with its third stronger-than-expected PMI report today. The better-than-expected PMIs this week are consistent with an expansion of around 0.5% in Q1, after a 0.3% contraction in the fourth quarter of 2011. The data reinforces our sense that the doves are unlikely to find more support for additional asset purchases at Thursday's MPC meeting.

We expect the BOE to move to a wait-and-see mode after the current asset purchase program is completed next month.

On the other hand, Australia reported an unexpected trade deficit of A$480 million (the consensus called for a bit more than A$1 billion surplus) and the January deficit was revised to A$917 million from A$673 million. Following other soft data this week and the dovish official comments, the sense that a May cut is a done deal is increasing.

Most emerging markets currencies weakened against the dollar and several local yield curves steeped in line with the sharp increase in U.S. Treasury yields following the FOMC minutes Tuesday. As expected, the more risk-sensitive currencies were hardest hit by the broad USD appreciation, notably ZAR, INR, RUB and KRW.

The moves reinforce out our view that being long high-beta currencies no longer offer a good risk-reward at this juncture. Perhaps more interestingly, the reaction in debt instruments may serve as a wakeup call for investors who are already concerned about recent negative headlines from budgets in several EM countries.

In India, for example, 10-year yields saw another leg up, rising as much as 20 basis points. Swap yields were up 12 basis points in South Africa and 5 basis points in Mexico.

U.S. Treasuries are paring back some losses Wednesday, but global fixed income investors will certainly remain cautions of the rising volatility in local markets.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.