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Yield differentials drive currency pairs

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Yield differentials drive currency pairs

The yield differential has been the driving force behind the rally in the US dollar.  Better than expected economic data released in the US over the past week has been the driving force behind the 10-year yield in the US increasing by more than 110 basis points 2.70%.  The climb in US yields has not been mimicked by European or Japanese yields which have generated a change in the yield differential.

Fed officials appear surprised by the quickness of the rise in interest rates and have tried to calm fears that tapering is not the same thing as tightening.  Market participants will get a better view of the Feds thinking when the Fed releases their FOMC minutes on Wednesday will likely be more hawkish than the rhetoric that followed the meeting.

The euro area economy continues to falter during the second half of 2013.  Industrial production figures due this week will likely support the view that the region is contracting.  The unexpected weakness in German industrial orders -1.3% v 1.2% consensuses, following a 2.2% decline in April may have helped prepare the market for today’s 1% decline in industrial production.

The 10-year yield differential between the US and Europe has broken through support levels touching the 1% in favor of the US level.  Higher yields will attract investors to the greenback, eroding the value of the EUR/USD.  The breakdown in the correlation between the yields and the currency are the largest seen in the past 3-years which is likely to lead to either a correction in US yields are a decline in the currency pair.

The EURUSD currency pair is testing support levels near 1.2745.  A break of this level could lead to a test of weekly support near the July 2012 lows near 1.20.  Resistance is seen near the 10-day moving average near 1.2975.

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