The 2-year beckons USD higher ahead of PCE inflation, risk-off tone in Asia

With two full-day of trade left for the month, the US 2-year yield is on track to snap a 3-month bullish streak. But with the Fed unlikely to cut rates soon and traders concerned that the cost of funding the deficit will send yields higher, yields could continue higher to notch up a 4^th bullish month if inflation data comes in hot tomorrow.

The daily chart shows a strong rally on the US 2-year, which retested 5% on Wednesday before retreating to close flat for the day. And that suggests 5% is clearly an area of interest for traders, who likely remember the false break above that key level before its yield quickly dropped back to 4.7%.

Should inflation remain sticky or come in hot, I suspect yields will break higher and drag the US dollar along with it. For now, the US dollar index (purple) remains at a discount to the 2-year, and that could allow for quite a rally for USD should the yield break above the April high - because where yields go, the USD tends to follow.

US core PCE is expected to slow to 0.2% m/m

A 0.2% m/m print for core PCE would see inflation below its own long-term average of 0.26. Yet core PCE y/y has remained at 2.8% the past two months, and unlikely to drop with recent monthly prints of 0.3%, 0.3% and 0.5% over the past three. And looking at employment and PMI data that has led us to this point, I have a hard time believing PCE will come in soft tomorrow.

From this perspective, PCE not ticking higher could be a welcome surprise. But should it heat up further from sticky levels, appetite for risk will be taken out the back for a good kicking. And traders are unlikely to want to hold risk heading into the close to avoid weekend gap risk, which could make for a messy end to the week as they stampede towards a small exit.

But we’re already seeing signs of risk off. Wall Street futures were lower and now cling to key levels of support, after weak bond demand sent yields higher – due to concerns of yields moving higher! And that worked wonders for the US dollar which is now eyeing a break above 105.20. The Nikkei 225 looks like it wants to roll over, and even gold and copper succumbed to US strength as it seems clear that the Fed are not likely to budge any time soon.

Risk off is in the air:

Whilst the US dollar remains firm against most FX majors, the Japanese yen is the strongest in Thursday’s Asian session with a late bout of risk-off. Copper broke to a 12-day low, gold is considering a move beneath $2320, US futures are lower and USD/JPY has erased all of Wednesday’s gains.

If this is the prelude of what to expect in today’s European and US session, we could be in for a rocky ride. But on the other hand, the Asian session is not usually the best one to take the lead from. So unless we see immediate follow-through after the European open, I suspect this could be a false move

-- Written by Matt Simpson

Follow Matt on Twitter @cLeverEdge