US/Euro 2year yield spread accelerating - SocGen
The widening in the US/Euro 2year yield spread has accelerated, and is closing in on 1997 highs, points out Kit Juckes, Research Analyst at Societe Generale.
“This is giving encouragement to dollar bulls (and to euro bears) and has dragged EUR/USD through the bottom of its micro-range. 1.1710 is the next significant support level and will probably be tested. There’s optimism that the US Tax Bill will boost growth and lead markets to rethink the speed and extent of Fed rate hikes, perhaps pricing in a Fed Funds peak closer to the Fed’s ‘dots’. Whether a tax cut for cash-rich multinationals and the very top end of the income distribution really boosts demand or investment isn’t clear, and 2.34% 10s clearly suggest the market isn’t yet convinced peak Fed Funds will be at 2.5% or higher but there’s enough chatter about the 2-year yield differential to make me wonder if we will finally flush out stale long Euro positions and shake a bullish EUR/USD consensus.”
“We think the relationship between 2-year interest rate differentials and FX rates was severely weakened at the end of 2014. In the case of EUR/USD, we have written (a lot) about the effect of volatility through 2008-2009, and of credit risk as shown by peripheral bond spreads in 2010-2014. Since the start of 2015, when the ECB moved to negative rates and a large-scale bond-buying programme, we have had more joy looking at relative real 10year bond yields, but even those didn’t ‘explain’ the euro’s strength after it jumped when ECB President Draghi brought up the idea of a further slowdown in the pace of bond-buying at the Sintra Conference. The 10-year correlation between 2s and EUR/USD is significant (r-squared over 0.7) but since the start of 2015 it’s close to zero and, to add insult to injury, the sign of the relationship is negative.”