FX sensitivities to yield differentials

April 1, 2011 — Mitul Kotecha

A lot has been made about the hawkish language from a few Federal Reserve FOMC members over recent days and growing speculation about whether quantitative easing (QE2) will end earlier than initially planned. In turn, this has been noted as a positive factor for the USD. Undoubtedly there are a few in the Fed who are becoming more nervous about current policy settings but it is highly unlikely that the Fed will not complete its $600 billion in planned asset purchases by the end of June.

The biggest imponderable is how and when the Fed begins its exit policy and how effectively/efficiently it can be done. Whilst it is likely to be over a year before the Fed Funds rate is hiked, the USD will be sensitive to balance sheet reduction. Moreover, the way in which the Fed reduces the size of the balance will also be important given the likely active approach to liquidity withdrawal required.

For the present, it should be noted that even with the hawkish Fed rhetoric and increase in US bond yields (2 year yields have risen by close to 25bps over the last couple of weeks) the USD is actually lower versus EUR than where it was two weeks ago. The reality is that German bund yields have risen by even more than US yields ahead of the anticipated European Central Bank (ECB) rate hike on 7 April (the case for which appears to have been sealed by the above consensus 2.6% YoY reading for March eurozone CPI).

However, I would be cautious about ascribing general FX moves at present to yield / interest rate differentials given that it is only EUR crosses (including EUR/JPY, EUR/GBP, EUR/CAD, and EUR/USD) that hold a statistically significant relationship with yields. All of this implies EUR crosses look supported ahead of the upcoming ECB meeting, with EUR/USD unlikely to sustain a drop below 1.4000 ahead of the rate decision. What happens after depends on the press conference. Bearing in mind that markets have already priced in 75bps of rate hikes by the ECB it would take an even stronger tone from the ECB to push the EUR higher, something that looks unlikely

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Contrasting messages from bonds, gold and equities

September 8, 2009 — Mitul Kotecha

There is an interesting divergence developing between bond yields, gold prices and the trend in equity markets.  Whilst equities continue to go up, bond yields are falling and gold prices are rising.  Indeed the usually strong relationship between the S&P 500 and US 10 year yields has collapsed to an insignificant correlation around -0.09 over the past month compared to a high correlation of 0.84 in the month to 8 August.  

Rising equities appear to signify an improvement in risk appetite whilst bonds (US 10-year yield around 3.4%) and gold (around $1000 per troy ounce) are giving the opposite message.  So which indicator is correct and why the breakdown in the usually solid relationship?  

Growing optimism about economic recovery and the run of better than forecast data releases suggest that equities are correct but there is growing risk that so much good news is now priced in that we should pay attention to what bond yields and gold prices are telling us.  

Some of the move lower in bond yields can probably be attributed to the wall of liquidity sloshing around due to central banks’ unconventional policy measures.  However, it is still remarkable that despite the plethora of better than expected data releases, bond yields have actually declined.  This may reflect the success of quantitative easing but could also be associated with sustained economic and market fears.    

The commitment by G20 officials last weekend not to reverse stimulus policies prematurely may also have given more confidence in the view that interest rates will not be raised quickly.  Reflecting this 2 year German bund yields dropped to a record low level at the beginning of the week although longer term bond yield have pushed higher in the 30 year area.  The G20 commitment could turn out to be a double edged sword, however.  If there is no commitment to reduce burgeoning deficits, bonds could ultimately take fright.  

If bonds and gold prices are really reflecting safe haven demand then it will pose a risk to the sustainability of any equity rally over coming months.  As equity valuations begin to look increasingly stretched – the P/E ratio on the S&P 500 has reached 18.76 (according to Bloomberg calculations) compared to a low of around 10.00 at the beginning of March 2009 – it will need more to keep the rally going and high amongst the factors needed is some clarity about the pace and shape of growth once stimulus is reversed. 

For currency markets I think it will be difficult to see a trend until there is more clarity about the economic outlook and in the meantime currency markets will continue to stock watch for direction even if the influence of risk appetite is declining.  Even so, the dollar appears to be reacting more to equities than bond movements and is coming under growing pressure as equities rise.  

Many currencies are poised to break out of recent ranges to the topside versus the dollar led by risk currencies such as the AUD, NZD and CAD.  If it turns out that the equity story rather than the bond message is the correct one then the real message is a bullish one for risk appetite and given the dollar’s usually negative reaction to improved risk appetite, it could face further pressure over coming weeks.

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