FX sensitivity to yield

December 9, 2010 — Mitul Kotecha

It’s all about yield. The back up in US bond yields in reaction to the US tax compromise from the Obama administration has been particularly sharp. US 10 year bond yields jumped around 35bps this week prior to a small correction in yields overnight whilst 2s were up 21bps. US bond yields are now back where they were in June, a fact that makes a mockery out of the Fed’s attempts to drive bond yields lower via quantitative easing (QE). Yields elsewhere increased too but by a smaller degree whilst equity market sentiment has been dampened by the rise in global yields although US stocks still ended higher overnight.

There is plenty of commentary discussing the impact on currencies of the move in bond yields so it’s worth looking in more detail how sensitive FX markets have been to yield. The most sensitive currencies i.e. those with the highest 3-month correlations with relative bond yield differentials (2 year) are the AUD/USD, EUR/USD, and of course USD/JPY. However, there is less sensitivity to gyrations in 10 year yields with no currency pair registering a statistically significant correlation with 10-year bond yield differentials over the past 3-months.

Assuming that US bond yields continue to push higher into 2011, with much lager increases in both nominal and yields expected, this means that AUD, EUR and JPY will face the most pressure relative to the USD. Moreover, the stimulus measures agreed by the US administration will likely lead to many analysts penciling in higher growth forecasts over 2011 whilst reducing the prospects of QE3 from taking place, all of which is USD positive. I still retain a degree of caution in Q1 2011, especially with regard to a potential bounce in EUR, especially if the ECB becomes more aggressive in its bond buying, but even so, any EUR rally is likely to prove termporary.

The impact of higher US yields on the AUD may be more limited however, despite the high correlation with relative bond yields, as Australian bond yields are also likely to rise somewhat given the resilience of its economy. This was clearly demonstrated by Australian November employment data released overnight revealing yet another consensus beating outcome of +54.6k, with all the gains coming from full time employment. Against the background of a generally firm USD, the best way to play AUD resilience is via the NZD, with the currency pair likely break through resistance around 1.3220 (21 October high).

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US bonds sell off, USD rallies

December 8, 2010 — Mitul Kotecha

US Treasuries didn’t like it but the compromise agreement to extend Bush era tax cuts, as well as a 13-month unfunded extension of long term unemployment benefits and a $120 billion payroll tax holiday will provide the US economy with further support and likely to lead to some upgrading of US growth forecasts. The agreement changes the dynamic of fiscal support for the US economy and means that the US is the only major country not tightening fiscal policy. It also implies less heavy lifting needed from the Federal Reserve.

Whilst some US taxpayers will not now face tax increases following the end of the year, the longer term question of fiscal adjustment and reform appears to have been postponed. US bond yields jumped on the news as the agreement effectively adds $1 trillion to US debt over the next couple of years. The contrasting fiscal stance with Europe could eventually haunt US markets as focus eventually return to US fiscal issues, with negative implications for the country’s credit ratings. However, at present, attention remains firmly fixed on European sovereign risk rather than US deficit fears.

There has been some relief to European debt markets, albeit temporarily, with debt markets ignoring the news that European Finance Ministers have not agreed to extend the size of the support fund (EFSF) and have also failed to agree on the introduction of recently touted “E-bonds”. ECB buying of peripheral bonds has given some support whilst the passage of the first votes of the Irish budget has eased tensions in its bond markets. Nonetheless as highlighted by the IMF, Europe’s ”piecemeal” response to the debt crisis in the region is insufficient to stem the crisis, suggesting that the current easing in pressure could prove short-lived.

The jump in US bond yields has given the USD some support but I wouldn’t overplay the impact on the USD of bond yields at present. Correlations reflecting the sensitivity of bond yields to various currencies remain relatively low suggesting that the influence of yield on FX is still limited. That said, the correlation is likely to increase over coming months as US yields move higher. The impact on USD/JPY is likely to be particularly sharp, with the currency pair likely to move higher over coming months. The USD has likely rallied due to the likelihood that the tax cut extensions will mean prospects of less quantitative easing by the Fed and prospects of relatively firmer US growth.

An ongoing concern for markets is the prospects of higher interest rates in China. As regular readers of Econometer many note, my blog posts have been a bit sporadic lately. This is not down to laziness but the fact that I have been on the road quite a bit travelling in Asia (and UK) visiting clients. One of the clear concerns that I have heard often repeated is the potential for China’s measures to curb real estate speculation, rising inflation, and lending, to slow China’s growth sharply and cause problems for the rest of the world. This is the topic of another post for another day, but against the background of such concerns the AUD and other high beta currencies are likely to fail to make much headway.

Posted in Australia, Bond markets, central banks, China, Currencies, Economics, Economy, equity markets, Europe, eurozone, Federal Reserve, Financial crisis, Fiscal/Budget, Ireland, Monetary Policy, Spain, US, US administration. Tags: , , , , , , , , , , , , , , , , , , , . Leave a Comment »

Drastic Action Needed

December 1, 2010 — Mitul Kotecha

There has been no let up in pressure on eurozone markets and consequently risk aversion continues to increase. The failure of Ireland’s bailout package to stem the haemorrhaging in eurozone bond markets highlights the difficulties in finding in a lasting solution and worsening liquidity conditions in several eurozone bond markets highlights the urgency to act.

Indeed, if spreads continue to widen as they have since late October, by early to mid 2011, Portuguese, Spanish and Italian Euribor spreads would be higher than the EFSF loan spread. In the (admittedly extreme) case that sovereigns could not raise money in the market, peripherals would run out of money early in 2011. Policy makers will try to not let the situation get so out of hand but what can be done to stem the damage?

The European Central Bank (ECB) may be forced to delay its exit strategy by maintaining unlimited liquidity allotments to banks into next year and/or implement further liquidity support measures. The ECB meeting will be closely scrutinized for details, with ECB President Trichet having to adjust policy accordingly. A further option could be for the ECB to step up its bond buying programme which may provide some relief to peripheral eurozone bond markets and the EUR.

Whether this offers a lasting solution however, is debatable. The risk of action by the ECB tomorrow may fuel some caution in the market towards selling the EUR further in the short term and could even prompt some short EUR covering around the meeting which could see EUR/USD regain a sustainable hold above 1.3000 again but this may be temporary, offering better levels to sell.

Meanwhile, speculation of a break up of the eurozone into a core euro and a peripheral euro has intensified given the growing divergence in growth and competitiveness across the region. Such speculation looks far fetched. The eurozone project has been politically driven from the start and over the last 60 years or so internal economic strains have been papered over by politicians. The political will is likely to remain in place even if the divergence in fundamentals across Europe has continued to widen.

Bond market sentiment was not helped by the fact that S&P put Portugal’s ratings on creditwatch negative citing downward economic pressure and concerns over the government’s credit worthiness. Importantly S&P still expects Portugal to remain at investment grade if downgraded. Note that Portugal’s central bank highlighted that the country’s banking sector faced “intolerable” risk unless the government implements planned austerity measures.

In contrast the US story is looking increasingly positive, highlighting that the USD’s strength is not merely a reaction to EUR weakness but more likely inherent and broad improvement in USD sentiment. US consumer confidence, Chicago PMI and the Milwaukee PMI beat forecasts in November, continuing the trend of consensus beating data releases over recent weeks.
Although this does not change the outlook for quantitative easing (QE) as the Fed remains focused on core CPI and the unemployment rate, the data paints an encouraging picture of the economy.

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