Yield Differential Still Seems in Charge of Euro versus US Dollar

Quotable

"All sentiment is right; because sentiment has a reference to nothing beyond itself, and is always real, wherever a man is conscious of it. But all determinations of the understanding are not right; because they have a reference to something beyond themselves, to wit, real matter of fact; and are not always conformable to that standard."

                              David Hume

Commentary & Analysis

Yield Differential Still Seems in Charge of Euro versus US dollar

To show a market correlation is to show a market correlation. That is about it. The reason I say that is because we can never really be sure which of the pieces of price data in the correlation is leading and which is following. And to go further, even if we did know which was leading we then run into the problem of then "forecasting"where the lead piece of price data is going in order to help "forecast" where the follower is going. Thus, I think correlation analysis is useful, but it must be handled with caution.

In that vein, you have probably heard plenty of people trying to forecast currency prices using a forecast of interest rates. I have been guilty of implying the same in my missives. But in reality, it’s a mug’s game to predict currency action by trying to forecast interest rates. Because as John Percival, of Currency Bulletin said many years ago, and I am paraphrasing: If we can forecast interest ratesthen why bother with currencies; just buy a seat on the Chicago Board of Trade and retire very wealthy. Wise advice as always from Mr. Percival…

Mr. Percival did go on to say that there is meat when it comes to interest rates, and it flows from the yield and inflation differentials. He said these differentials "seem to be the basic fundamentals of currency analysis." Change is what moves prices, and "in currencies, changes in real yield differentials are a basic value benchmark."

So, in that vein, below is a chart of the US versus Eurozone 2-year Benchmark Yield Differential. As you can see, the US dollar index has been tracking closely on the yield differential i.e. as the spread moves higherin favor of the US, the dollar index rises, and vice versa.

This differential analysis could become increasingly important now that we finally seem to have exited the pure and mind-numbing "risk on" and "risk off" world of investing.

So, I think it is fair to expect (guess) that US economic growth is most likely to be faster than Eurozone growth in the months ahead. If that proves true, then it’s likely the 2-year yield differential will continue to grow in favor of the US dollar. And it’s a key rationale for why I expect the move higher in EUR/USD over the last 10 trading days is "corrective" in nature and the longer term downtrend will reassert itself soon.

But, surprise is what moves people to move prices. And just because careful consideration goes into a guess about the future, doesn’t make it so. Spain reported today the country’s unemployment level fell for the first time in two years. So, we can never say "never," and that’s why we trade using stops (mental or otherwise).

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[Correction: In yesterday’s Currency CurrentsIsaid I expected bond prices to "go lower" in the months ahead. I meant to say bond prices to "go higher." Sorry for the error.]

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