US bond yields hold key to dollar rally Currency traders have grown used to paying less attention to government bond yields as a big influence over foreign exchange markets since the financial crisis. But that may be about to change after a sudden jump in yields on US Treasuries. The potential "game changer" for the dollar has been a recent improvement in US economic data that strategists believe lessens the odds of the Federal Reserve embarking on a further round of quantitative easing, or QE3, in the coming months. While the Fed maintains that it is likely to keep overnight interest rates near zero through to at least 2014, the rise in benchmark 10-year Treasury yields, from less than 2 per cent to as much as 2.39 per cent in matter of days, suggests investors think the central bank may act sooner to curb inflationary pressure. The question for currency traders is whether the bond market sell-off will gather pace as more good news on the economy boosts the stock market, underpinning a revival in the fortunes of the dollar. The Fed's QE bond-buying programme has weighed on the US currency for much of the past three years. "The fate of the dollar lies in the hands of US yields and US equities," says Kathy Lien, a director of currency research at GFT Forex. With Treasury yields at five-month highs, a number of analysts believe the dollar is poised for a sustained rally. Against the Japanese yen, the dollar is trading at around Y84, its highest level since April last year. Gold has been a casualty of the dollar's rebound, too. The dollar strength has legs. And interest rate differentials are playing a huge part in this," says John Taylor, founder of currency hedge fund FX Concepts. Much of the turnround in the US bond market, dollar and gold has occurred in the past week, with a near doubling in the yield on the US two-year note to 0.40 per cent. By contrast, yields on two-year Japanese government bonds have been steady at about 0.10 per cent, contributing to the weakness in the yen. Positioning data show bearish bets against the yen at their highest in nearly a year. Marc Chandler, strategist at Brown Brothers Harriman, says the difference in the countries" respective two-year rates should remain a dominant driver of the dollar-yen exchange rate. The euro, meanwhile, has bounced off the $1.30 level, through which it nearly fell last week, to trade at more than $1.32, bolstered in part by two-year German yields doubling over the past week to 0.33 per cent. "With the euro seeing a bounce after the failure to take out the 1.30 level, we need to see these interest rate differentials turn higher for the dollar to give the dollar rally another boost," says Mr Chandler. The euro is seen as likely to lose ground as the European Central Bank continues pouring funds into the banking system. John Doyle, a director for markets at Tempus Consulting, says that while the euro has been trading in a narrow range against the dollar, the balance may tip in favour of the US currency as rates rise. "For the time being, we are shorting the euro," he says. The $1.30 level was held for much of 2011 and, even as the eurozone crisis intensified, the dollar could not sustain a break through that mark. It is a level that looks vulnerable should the Fed rule out further QE in the coming months, effectively leaving the euro vulnerable to any further ECB easing. Others contend that it will take a good deal longer for the dollar to shake off its recent weakness. The value of the dollar against a basket of currencies shows how the US currency remains at weak levels compared with its global peers. While the dollar index is up 11 per cent from its record low set in April 2008, it is still well below levels of a decade ago. "On a trade-weighted basis the dollar is still quite weak," says Daniel Katzive, director for global foreign exchange at Credit Suisse. Rate differentials may favour the dollar and we may see some further gains. [But] the "strong-dollar" alarms are not sounding yet."