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In
Chris Lori's Forex Pro Traders Club and other commentary we discuss
interest rate differentials as a primary FX driver.
We look at how
yield differentials have moved for EURUSD and USDJPY as part of a
broader look at the recent rally in Treasury yields.
In the current environment, we would advise some caution in
determining that yield spreads will become a material driver of the FX
markets. First, it is unlikely that volatility will remain subdued in
light of the Greece crisis and normalisation risks. Bond vigilantes may
be ready to come out in droves, but central banks will call their bluff
in the current growth environment, leading to significant instability in
yields. As such we would position for a general rise in FX volatility.
As for yields, we will maintain focus on AUD, NZD and the coordinated
positioning of BoC and the FED. The FED first needs to bring the bank
rate higher before tightening the OCR.
Since January, the ECB has acknowledged that Eurozone fiscal problems
are hurting their exit strategy, while benchmark yields have also fallen
sharply. The 2-year yield differential between the Eurozone and the US
has turned negative for the first time since late 2007, though the
extent of the decline in EURUSD suggests that other factors are at play,
such as asset liquidation flows, which have been prominent for the past
few months. The ECB would probably welcome this additional source of
stimulus for the time being so long as imported inflation is kept in
check, but its normalisation is now almost certainly going to lag the
Fed's by far.
The picture is similar in USDJPY, which tracks yield differentials even
more. The relationship between USDJPY and the 2-year spread has
traditionally been the strongest but this week's jump in the pair has
been driven by the 10-year. There has been some abnormal price action in
this part of the curve in fixed income as we highlighted in the
negative 10-year swap spread of late, but for FX this is simply another
step in the process towards normalisation. Japanese investors in
particular are expected to be yield-centric as benchmark BoJ lending
rates have been the lowest in G10 for many years and spread capture is
the main determinant in a 'normal' interest rate environment. As such,
the move in USDJPY suggests that carry investors expect rate spreads
will materialise soon, despite the natural protestations of many central
banks to the contrary.
Banks have
brought forward their forecast for the next RBA rate hike to the May
meeting (with the risk of a move on April 6) and to be followed by
another in July (with risk of one in June). Previously August had been
seen as the most likely time for the next hike.
A speech by RBA Governor Stevens made no mention of the domestic
economic situation and did not refer to the interest rate outlook.
However, Stevens became the latest G10 central banker to advocate
greater exchange rate flexibility in Asia saying that higher Asian
exchange rates could result in better standards of living.
We maintain our
Long Only AUDJPY strategies covered in Pro Traders Club
Source: UBS,
Bloomberg, Chris Lori CTA
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