By Yasin Ebrahim
Investing.com – The dollar rallied Monday, riding on the coattails of surging U.S. bond yields, but rising rates could be in for a rough ride as the bond market is writing checks the Federal Reserve can't cash as the central bank has made it clear it will not tighten policy anytime soon.
The U.S. dollar index, which measures the greenback against a trade-weighted basket of six major currencies, rose by 0.38% to 92.33, driven by a move higher in U.S. rates on the back of expectations for a fresh round of stimulus.
The Senate passed the $1.9 trillion stimulus plan on Sunday, and the House will vote on the bill on Tuesday, with many expecting the legislation to be signed into law by 14 March to ensure unemployment programs set to expire in mid-March don't lapse.
The Senate package includes direct payments of $1,400 per person for families earnings less than $160,000 per year or individuals earning less than $80,000 per year.
But Treasury yields have approached overbought levels, and could face fundamental headwinds ahead.
"In 'Top Gun,' terms, the bond market's ego is writing checks the FOMC's body can't cash [...] as the bond market is pricing in Fed rate hikes well before the Fed is prepared to deliver them," Morgan Stanley (NYSE:MS) said.
In a rising rate environment, bonds today are worth less than bonds in the future, sparking a wave of selling and pressuring prices, which trade inversely to yields. But the appreciation in yields could eventually become too attractive to ignore.
"Banks in Japan sold a tremendous amount of bonds in May and June 2013, as US Treasury 10-year yields went from 1.75 % to 2.75%, but then banks and pensions funds in Japan began to buy," Morgan Stanley added. "History suggests investors in Japan will not abandon the US rates market forever, especially given the more attractive yields levels today."