What does the past tell us?

The U.S. economy experienced a similar scenario in April of 2006. On Jan. 23, 2006, the 10- year T-note yielded 4.36 percent — one basis point lower than its yield on the first day of 2006. By April 26 (roughly the same time period as our current scenario), its yield had climbed 76 basis points to 5.12 percent, and it remained at or above 5 percent through July 28. Strong new home sales and robust orders for durable goods helped propel long-term interest rates higher.

How did the dollar perform vs. the Euro during this time period? On Jan. 23, the euro/dollar (EUR/USD) rallied strongly to close at 1.2303. By April 26 it had rallied to 1.2453 — meaning, the dollar had weakened vs. the euro. The EUR/USD pair continued to rally into May before pausing and eventually reaching a high of 1.2979 in early June 2006.

Arguably, the improving health of the U.S. economy should have been reflected in a strengthening dollar. As it turned out, U.S. economic activity was so robust the Federal Reserve raised the federal funds rate at both its May 2006 (to 5.00 percent) and June 2006 meetings (to 5.25 percent, where it currently stands).

At the same time, though, the Eurozone economy was quickly gaining steam and the European Central Bank (ECB) had embarked on a campaign to raise short-term interest rates. One possible explanation for the relative strength in the euro vs. the dollar is that traders were expecting the gap between short-term interest rates in Europe and the U.S. to narrow.

In theory and generally speaking, the dollar should strengthen when long-term rates are rising. But as shown here, other factors may outweigh or completely override any possible lift the dollar might expect to see from rising long- term rates.

Nonetheless, although short-term interest rates are usually the focus of currency analysis, long-term interest rates bear watching, especially in regard to fundamental economic concerns that drive the big-picture action in the forex market.