USD: Asset allocation shift out of bonds to hit EUR/USD

	USD: Asset allocation shift out of bonds to hit EUR/USD Asset allocation shift out of bonds remains positive for the USD. The USD has tracked the performance of bonds very closely over recent months. Rising yields have been associated with a firmer USD and viceversa.The correlation between US Treasuries and the USD has risen to as high as 0.94 over the last 30 days and has been consistently significant (higher than 0.75)since mid 2002. Using a simple regression to estimate the strength of this relationship, we estimate that every 10 bps rise in 10 year yields corresponds with a 1.3 point rise in the USD index. In particular, the relationship between bonds and EUR/USD appears to have been very strong. As money shifts out of bonds in general, the euro-zone, whichhas seen a much a greater proportion of portfolio inflows in the form of bonds over recent months (60% of all portfolio inflows have been into bonds compared to 27% for the US in the last 12 months) is likely to suffer. The out-performance of euro-zone bonds compared to Treasuries since the beginning of the year also suggests that the risk of profit taking on euro-zone bonds is higher. More worrying for the euro is the fact that much of the investment into US Treasuries from foreign investors may have been hedged (especially by Japanese investors) in contrast to the inflows into euro-zone bonds. As these flows reverse, the EUR will suffer relative to the USD. Over recent days, EUR/USD has not reacted to the run up in bond yields,suggesting that there may be some catch up over the shortterm. Data releases and earnings are likely to support this view. Today’s weekly chain store sales numbers will add further evidence of firming consumer spending, whilst positive earnings after the close from Texas Instruments point to a positive opening to US equities. As a result, EUR/USD is likely to slip to support at 1.1245 over the next couple of days, with risks of further short-term weakness. USD bloc: Rate cut in New Zealand tomorrow and growing chance of Australia following next month. Remain bearish AUD,NZD, CAD.After the big sell-off of the last couple of weeks, the USD bloc currencies have found some support in the last few sessions. Notably, despite another bloodbath in bond markets overnight, AUD, NZD and CAD are largely unscathed. Does this suggest the worst is over for these currencies? We think not as all three face on-going pressure for easier policy and, more importantly, waning investor yield appetite. The next major event this respect is the RBNZ rate announcement (22:00 BST tomorrow, rates currently 5.25%). A 25bp is fully expected, but, with policy as tight as it is, and no meeting during August there is a reasonable chance of a 50bp move. If this does not come at this meeting, then we remain confident that at least 25bp more will be forthcoming in the remainder of the year. This compares to a futures strip that is basically flat at 5% for the remainder of the year. The RBA meets in two weeks time and the pressure is clearly growing for a move following significant easing elsewhere in the world. A 25bp cut from the RBA now seems more likely than not, particularly if tomorrow’s CPI data are as soft as we expect. As we have highlighted before, however, how investors react to yield is as important as yield itself in the case of the USD bloc. And as yield appetite continues to decline, the USD bloc will continue to weaken. Looser policy just adds to this pressure and we maintain a bearish view on the three currencies.

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