Prospect of early U.S. rate hike boosts dollar, bashes bonds

[May 19, 2016]  By Marc Jones

LONDON (Reuters) - Revived prospects of an early U.S. interest rate rise, possibly as soon as June, lifted the dollar to a near two-month high on Thursday and left bonds, stocks, commodities and emerging markets all nursing losses.

Minutes from the Federal Reserve's last meeting caught the market off-guard by revealing most policymakers thought a June rise would be "appropriate" if the U.S. economy continues its recent improvement.

That suggested the central bank is closer to lifting rates again than most investors had expected and saw a scramble from traders to readjust.

Wall Street was expected to open 0.5 percent lower.

European stocks  were off 0.7 percent after the disappearance of plane going from Paris to Cairo spooked travel stocks and as traders grappled with the prospect of higher global borrowing costs.

With U.S. Treasury yields sharply higher, the dollar  stayed strong after scaling its highest level against other top currencies since late March. That in turn buffeted emerging and commodity markets that correlate closely with both.

"A June hike is definitely back on the table," said UniCredit's Global Head of FX Strategy Vasileios Gkionakis.

"The bottom line is that the market is going from an excessively complacent view (on the likelihood of Fed hikes) to a more realistic one."

Benchmark U.S. Treasuries  were starting to stabilize after one of their biggest sell-offs in almost three years.

Germany's 10-year Bund yield hit a two-week high before pulling back slightly as traders digested what were resolutely dovish ECB meeting minutes, although tinged with optimism about the euro zone economy.

Analysts said concern about the EgyptAir plane that went missing could also be lending the safe-haven German market some support.

CME Fed fund futures showed that the probability of a June U.S. rate increase rose to 34 percent after the release of the FOMC minutes on Wednesday from 19 percent earlier in the day, 15 percent on Tuesday, and less than 1 percent a month ago.

U.S Treasury yields have backed up considerably, with 10-year rates close to 1.90 percent and up almost 20 basis points since Monday. Two-year rates at 0.91 percent are at their highest since mid-March.

"With April activity indicators consistent with a healthy bounce-back in growth, we see risks of two rate hikes in 2016, with the first coming in the June/July time horizon," strategists at Barclays said.

BIG IN JAPAN

But many in the market are still skeptical the Fed would raise rates before Britain's June 23 referendum on whether to remain in the European Union, a risk noted by some Fed policymakers. July may be a stronger possibility.

Retail sales data from Britain on Thursday showed the Brexit angst that has dented business confidence in recent months is having no impact on shoppers, helping push sterling to its highest since February.

Fed Vice Chairs William Dudley and Stanley Fischer are due to speak later in the day and the markets will be eager to get more details on the Fed's thinking as G7 finance ministers and central bankers prepare to meet in Japan on Friday.

Gold which tends to be inversely correlated to monetary policy easing, fell 0.1 percent to a three-week low of $1,256 per ounce, while MSCI's main EM stocks index and China's yuan currency both hit 2-1/2 month lows.

The greenback also weighed on commodities such as oil, with U.S. crude futures losing 0.4 percent to $48.00 a barrel. A stronger dollar tends to put non-U.S. buyers of dollar-denominated commodities at a disadvantage.

"We suspect the oil market has moved too high, too far, too soon," French bank BNP Paribas said, as a near 60 percent surge in Iranian output added to price pressure. [O/R]
 

Overnight, South Korea and Australia had led Asia Pacific markets lower with 0.6 and 0.8 percent falls to dovetail with the latest fall in the yuan.

Moody's said in a note that rising leverage in China and emerging markets in general is an even greater concern now that the possibility of another U.S. interest rate hike this summer is back on the table.

Japan's Nikkei rose early thanks to a weaker yen, which fell to a three-week low of 110.37 against the dollar, but later erased almost all its gains.

"In the short term, emerging markets are the most vulnerable," Steven Englander, global head of G10 FX strategy at Citibank wrote in a note to clients.

"Overall, the divergence trade is revived until further notice," he added, saying the Canadian and Australian dollars were also vulnerable due to concerns around their economies.

(Editing by Catherine Evans)

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