The recovery of Asian equities paused on Tuesday, following a pullback in Europe yesterday and the likelihood of U.S. stocks opening in red when traders return to their desks after a long weekend. The Japanese Nikkei 225 led the losses, falling more than 1% with declines hitting all sectors but utilities.  Meanwhile, the Hong Kong’s Hang Seng Index recovered early losses to edge up slightly higher on the first trading day of the Year of the Dog. China remained closed for the Lunar New Year and will return on Thursday.

The greenback, which was hit aggressively last week, rebounded against its major peers, with the Dollar Index up 1.2% from the three-year low recorded on 16th of February.  Given that U.S. markets were closed for Presidents’ Day and no data was released, there wasn’t any specific trigger for the dollar’s rally. Traders have been struggling recently to find a reasonable correlation between fixed income markets and currency markets, as the dollar was not responding to the differentials in bond yields. However, it’s becoming evident that a pullback in equities is becoming a positive indicator for the U.S. currency and vice-versa. This relation is likely to hold for the short-run, as risk appetite continues to support outflows from the USD to other major currencies.

Investors have been dumping the dollar despite the increase in bond yields, as many focused on the rising twin deficits instead. This week will certainly be interesting for bond investors, as the U.S. government plans to sell $258 billion worth of debt. The combination of rising inflation and mounting budget deficit comes at a cost and investors will decide how much extra premium they require on holding U.S. debt. I think the short end of the yield curve looks relatively attractive with the 2-year bond yields currently at a 9-year high. However, it’s the long end which matters the most in the current environment, as a break of 3% on the U.S. 10 year-yields is likely to test investors’ confidence in equities.

The Euro is also in focus with the German ZEW to be released later today. The sharp selloff in European equities two weeks ago should have dented investors’ confidence, and this will reflect in today’s figures. Euro traders should also watch politics in Germany, as the Social Democratic Party will hold a ballot today to ask their members if the SPD should enter into a coalition with Angela Merkel. Although the results won’t be announced until 3rd of March, an early indication of how the voting goes is likely to impact the Euro.

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