One way to better grasp the improving correlation between yield spreads and the EUR/USD is shown in “Liquidity breach, ”which highlights the actual correlation between the German-U.S. differential and exchange rate.
Note how the impact of yield spreads grew especially relevant (highly correlated) in January 2010 when members of the Federal Open Market Committee started to voice hawkish concerns, favoring reduced liquidity. That was in contrast to the European Central Bank, which was expected to maintain generous liquidity (if not add more) to alleviate the risk of a liquidity shock stemming from any worsening of conditions in Greece and Portugal.
The February increase in the U.S. discount rate, the first since 2006, was largely seen as a prelude to higher interest rates in general. But even if the more relevant Fed Funds rate target remained unchanged into the rest of the year at 0-0.25%, traders reasoned the yield differential remained well superior to that in the Eurozone.
Traders who are not well versed in the matters of recent fundamentals can simply relate “Liquidity breach” to “Yielding bounty” to reconcile correlation shifts to turnarounds in spreads. One example is how “Liquidity breach” illustrates the rise in correlation from late 2006 into most of 2007. Looking at this period in “Yielding bounty,” we find the German-U.S. differential has recovered more than 120 basis points from its lows of summer 2006 to neutral (0.0) in 2007.
Currency traders capitalized on this euro-positive development as German yields had nowhere to go but up. Fundamentally, summer 2006 marked the end of the Fed’s two-year tightening cycle in contrast to the European Central Bank, whose tightening cycle did not begin until May 2005 and extended into 2008, well after the Fed had ceased raising interest rates.
This contrasting picture was appropriately captured by an improving German-U.S. differential and a rising EUR/USD, hence a rising correlation between the two variables. Today, the correlation is once again picking up on the heels of a deteriorating German-U.S. yield differential and a falling EUR/USD rate.
Considering past cycles in the interrelationship between German-U.S. spreads and EUR/USD, expect the spread to near -100 basis points by mid-second quarter from the current -0.50 bps, thereby increasing the risk and dragging EUR/USD down to $1.28. The fundamental catalysts for this forecast are not only driven by contrasting dynamics (Fed hawkishness and ECB dovishness due to Eurozone fiscal woes), but also by the escalating risks to global risk appetite (excessive Chinese tightening, resurfacing debt crisis in Dubai, political uncertainty in the United States).
The U.S. fiscal situation is by no means fixed, but the immediacy of currency flows in a risk-averse environment and contrasting yield dynamics are likely to take precedence in favor of the greenback.
Ashraf Laidi is chief strategist at CMC Markets, author of “Currency Trading and Intermarket Analysis” and founder of www.AshrafLaidi.com.