[DanRath]

Late last week, both the USD and US bonds sold off as focus was put on the US government's debt dynamics following the S&P putting the UK sovereign debt rating on negative watch. The combination strongly suggests an increase in the risk premium on US government and USD denominated assets. Though equities fell somewhat in response, their decline was relatively muted. This is a crucial issue going forward. If investors lose faith in the US government's ability (or desire) to stimulate the economy in the short run, it will put greater pressure on the Fed's QE programme, and would raise the possibility of a vicious circle arising: higher yields mean more QE required, leading to greater concern about the possible monetisation of US debt, leading to higher yields, and so on. The green shoots that some can see have been fertilised by policy action - but the effectiveness of policy is dependent on markets retaining their faith in its longer-term sustainability.

For these reasons, the most important events this week may be the US Treasury auctions: USD40bn of 2 year; USD35bn of 5 year; and USD26bn of 7 year debt - a huge amount of issuance. The Fed is due to buy securities at the 3-4 year part of the curve this week, so the 7 year auction will be especially interesting. Both the cover ratio and the level of non-commercial participation will matter in addition to the yield. Weak demand will spell problems for equities and FX.

USD may not be the most vulnerable currency in the short run given its sharp falls last week. Instead the traditionally risky currencies may be vulnerable, particularly the CAD and NZD, both of which appear to be overvalued relative to the USD. The EUR is also markedly overvalued. Longer-term though, the continued confidence of international investors that US policy will keep monetary policy focussed on low and stable inflation, US fiscal policy on a sustainable path and the US economy from slipping back into deep recession is crucial for the attractiveness of the USD. Analysts remain medium-term USD bears but advise caution in the short run.