OVER the past several weeks, the FX market has undergone a monumental change. Bonds not stocks have become the primary driver of trade for currencies and that one dynamic has been able to explain most of the movement in the dollar both up and down. Instead of the old mantra of “Show me the money!” currency traders are now screaming, “Show me the yield!”

The dollar has had an amazing run over the past few weeks, as better than expected US economic data including relatively robust labour numbers helped to spark a rally in yields, while at the same time turning the risk trade upside down. Typically, positive US economic data would lead to a rally in US stocks which in turn would spark buying in high beta currencies like the pound, the Aussie and the euro. However, over the past few weeks that relationship broke down completely as both US equities and the US dollar rallied in tandem. Instead of taking its cue from stocks, the FX market followed bonds as currency traders suddenly became fixed income traders. The higher the US bond yields rose, the more powerful the upmove in greenback became.

On Friday, however, the rally in the dollar came to a screeching halt as both the CPI data and the University of Michigan consumer sentiment survey missed their mark – tempering the rally in US yields while unleashing a vicious short covering drive in euro-dollar that continued on Monday with euro-dollar tacking on nearly 250 points in two days.

Just how far this correction in the dollar rally will go will depend on this week’s US economic data, which is mostly dominated by reports from the housing sector. The week starts with Tuesday’s new building permits and ends with Friday’s new home sales release – due at 17:00 GMT will offer the market a look into a key part of the US economy.

Housing has been moribund for nearly four years, but recent data suggests that the sector may have bottomed out and that demand is beginning to recover. If the housing numbers beat their mark, they will provide yet another piece of evidence for the US recovery thesis and will likely push bond yields higher on speculation of better US growth. However, the rise in gasoline prices which has seen its 10th straight day of hikes at the pump, along with the increase in mortgage rates, could prove to be a nasty surprise for dollar bulls if it results in a downward print on the housing data, prompting fresh speculation on another round of quantitative easing.

Meanwhile in Europe the focus will turn to this Thursday’s flash PMI data. The manufacturing and services PMI reports provide the absolute latest readings of conditions on the ground. Markets anticipate a slight improvement from the month prior, but still forecast a reading below the 50 boom/bust line. If however the European data shows a rebound in economic activity in the wake of the resolution of the Greek crisis, then the short covering rally in euro-dollar could have further to run with the pair pushing higher for a possible test of the $1.3400-$1.3500 level which represents the 38.2 per cent retracement from the highs of last May. It is unlikely that the latest price action in euro-dollar represents some sort of major change of trend, but don’t be surprised if the pair continues to squeeze higher – much to the bewilderment of dollar longs.