Decoding bond market dynamics: Key to your first FX trades of the year

As we navigate year-end flows, the dollar could weaken on position squaring and year-end FX/Equity ratio rebalancing despite a prevailing bullish outlook for 2025.

The upcoming weeks may prove inconsequential in the macro sphere unless unexpectedly weak U.S. data comes. Expectations are mounting that President Trump will kick off his term aggressively, targeting countries with significant trade surpluses against the U.S. with a barrage of tariffs. This anticipation could influence market dynamics significantly, reshaping the typical start-of-the-year currency flows.

In China, recent disappointing data continues to pressure domestic policymakers to intensify their policy stimulus to invigorate domestic demand. Following last week's announcement, it's clear that China is set to ease both fiscal and monetary policies to bolster growth in the coming year. This week, yields on Chinese government bonds plummeted to new lows, with the 10-year yield reaching a startling 1.72%, marking a 30 basis point drop this month alone. Market whispers now suggest that the People's Bank of China (PBoC) might further cut the reserve requirement ratio before year-end. This persistent drop in Chinese yields could lead to further renminbi depreciation, particularly as looming U.S. tariff hikes on Chinese imports are expected to commence early next year.

In stark contrast, U.S. yields have rebounded this month, expanding the yield differential between the U.S. and China. The 10-year U.S. Treasury yield has recovered from a low of 4.13% on December 6th, approaching recent peaks around 4.40%. This uptick in U.S. yields comes despite markets pricing in an additional 25 basis point rate cut from the Federal Reserve this week.

The Fed's updated guidance on future rate cuts will be critical for the direction of the U.S. dollar after this week's Federal Open Market Committee (FOMC) meeting. Recent remarks from Federal Reserve officials, including Chair Jerome Powell, have signalled a more cautious approach to rate cuts. The question is, how long is a pause? This shift in Fed strategy could significantly influence global currency markets, particularly affecting the dynamics between the U.S. dollar and other major currencies.

Bond markets dynamics

US Treasury yields have surged, spurred by aggressive mutual fund actions shedding duration amid speculation over a potential January pause by the Fed. Despite a probable 25 basis point cut this Wednesday, the relentless sell-off in longer-dated assets highlights a shifting sentiment. Over the past three weeks, mutual funds have liquidated approximately 4% of their long-dated holdings, with the cumulative impact becoming evident as supportive fast money flows recede. Now, market players are squaring positions as year-end approaches and could push 10-year notes beyond 4.45%.

The upcoming PCE inflation readings could further complicate narratives, expected to show a 0.2% month-on-month increase, contrasting the recent 0.3% MoM core CPI, cementing the U.S. within a "3% inflation economy." This backdrop supports the view of a Fed pause in early 2025, especially with the unpredictable economic policies likely under the incoming Trump administration.

In the Eurozone, the focus sharply contrasts, centring on domestic growth concerns rather than inflation. Recent inflation data below the ECB’s 2% target signals deep-rooted pessimism about long-term prospects, pushing euro rates lower even as U.S. rates climb.