NEW YORK, July 26: As currency investors ponder the future direction of the battered US dollar, determining the true cause of the recent surge in US Treasury yields may be a crucial first step.

If incipient optimism about the US economy picking up its pace in the second half of the year turns out to be well founded and proves a convincing explanation for the climb in yields, then the dollar should reap some rewards.

Under this scenario, investors should buy the dollar and sell bonds as bond yields continue their march higher, Alex Patelis, senior G10 foreign exchange strategist with Merrill Lynch, wrote in a research note.

But if the US economic recovery proves elusive or if the meteoric rise of Treasuries’ yields is mainly to to technical factors, it may be advisable to sell the dollar, Patelis wrote.

Despite stronger-than-expected US durable goods data on Friday and a steeper-than-expected fall in jobless claims reported on Thursday, these hints of a rosier economic scenario may be an excuse, rather than the main motivation for the spectacular plunge in Treasuries prices.

Expectations of a growing supply of government bonds as the US budget deficit widens, creeping concerns about long-term inflationary pressures and heavy mortgage-related selling of Treasuries constitute another reasonable explanation for the jump in yields.

By contrast, if benchmark 10-year Treasury note yields are around 4.2 per cent because of an impending economic recovery, the US dollar is a buy, Patelis wrote.

Treasury yields — which move inversely to prices — have jumped higher, rebounding one whole percentage point to 4.19 per cent on Friday from their 45-year lows near 3 per cent roughly a month ago.

That bungee jump has left some fixed-income investors with the stomach-churning sensation that the US economy, supported by some improvements in corporate earnings, is finally back on track to faster growth.

A picture of improving US economic health is still sketchy. But just as Treasury bond yields anticipated a long period of low interest rates and sluggish economic growth when the yield curve inverted in early 2000, Treasuries could now be front-running an economic recovery scenario, Patelis noted.

Over the past few weeks, currency traders have increasingly viewed rallying US equity markets and higher bond yields as potential proxies for economic growth. Currency market investors have accordingly started to factor in US growth prospects as lending the greenback some luster.

Despite the continuing weight on the greenback of the hefty US current account deficit — currently around 5 per cent of gross domestic product — some have the sense that economic factors are starting to play, albeit sporadically, to the dollar’s advantage.

The US economy is showing some signs of possibility for longer term growth, said Thomas Molloy, a trader at Bank Leumi in New York. That is garnering some limited support for the dollar. Some traders are not confident that US stock market rallies during recent months can prove sustained.

If previous trends hold true, the stock market may continue to fall even if earnings recover in subsequent years, wrote Jes Black, currency strategist with MG Financial Group in New York, in a research note on Friday. —Reuters