The prospect of the Federal Reserve tapering its quantitative easing (QE) programme has been the main pre-occupation of currency investors during the past month, but there are wider forces at play that suggest a regime shift in the FX market.
The dollar index has risen by about 3.5% this month. Furthermore, the dollar has been the best-performing G10 currency in 2013, supported by rising real yields in the US.
Stronger-than-expected US consumer confidence and housing data on Tuesday sent the US yields to their highest level this year. Ten-year US Treasury yields hit 2.21%, their highest level since April 2012, while two-year yields surged to above 0.3%, levels not seen since October.
Part of the sell-off in US fixed income and rise in the dollar is being triggered by heightened expectations that the Fed will rein back its QE programme, but price action in FX suggests there are other dynamics at work.
This dollar move still has a very long way to go and its now being driven by the shift in yield differentials, and it is creating all sorts of problems for those stuck in the past, trading on out-of-date correlations, says Maurice Pomery, chief executive at FX consultancy Strategic Alpha.
This rise in yields is the most serious development that is facing the global market place and the Fed, and its impact requires us to change established views on trading strategy.
Indeed, price action during the past month suggests that Fed QE tapering has not been the main driving force of price movements.
As Richard Yetsenga, head of global markets research at ANZ, points out, if that were the case, then other zero interest rate currencies would have sold off, while equity markets would have struggled.
In the event, however, equity markets have remained relatively robust, at least until the recent corrective price action led by Japan, while the euro and the pound have been among the most stable currencies during the past month.
Yetsenga says rather than focusing on potential Fed tapering, investors should concentrate on the declining tail risks of a collapse in global growth and an overshoot in inflation.
It is the reduction in growth tail risks that has brought the Fed to the point of considering some tapering, he says.
At the same time, the near-uniform fall in global inflation indicators has reduced fears of a destabilizing QE generated rise in global inflation.
That has encouraged a shift back into equities, particularly in developed markets, and a reassessment of owning relatively expensive peripheral bond markets with high foreign-ownership levels.
Global equity fund flows (weekly, $billion)
That regime change would suggest that even if the market pushed back expectations of Fed tapering the current consensus is for it to start early in the fourth quarter then non-dollar currencies will not benefit as uniformly as they might have done previously.
While euro and sterling might well gain support from such a push back in expectations, the broader picture will remain negative for commodity-linked and emerging market (EM) currencies.
That is because the reduction in fears over global growth and overshooting inflation appears to be reducing the need for investors to diversify their portfolios.
Diversification has been the main theme on global markets in recent years. Global investors have reallocated capital from equities to bonds amid growth concerns. Over time, QE-generated inflation concerns in developed economies saw a further reallocation of capital away from core G4 bond markets towards EM and the commodity bloc.
With global growth and inflation fears receding, diversification flows might have peaked regardless of the exact timing of the start of the Feds pullback from its QE programme.
That would explain the recent breakdown in the positive correlation between risk and EM and commodity-linked currencies, not to mention the negative correlation between the dollar and improving investor sentiment.