“The trouble with the world is that the stupid are cocksure and the intelligent are full of doubt.”
Commentary & Analysis
EU versus US Yield Spread: It seems to matter for the currency
If you can forecast interest rates, you should just trade bond futures and make a fortune and forget about currencies, to paraphrase John Percival of Currency Bulletin. John’s point was simple and it was two-fold: 1) You shouldn’t base your currency forecast on your interest rate forecast; 2) Because no one can consistently forecast interest rates and even if you could it doesn’t mean it will help you with your currency forecast. But most currency traders do watch interest rates. That is because over time there doesseem to be a correlation between rising a country’s rising yield differential (if for the right reason and usually driven by internal factors) and that country’s relative currency value.
Interest rates are the real fundamental factor operating continuously in the background of the currency markets. Sometimes there is very little correlations between differentials (or spreads) of one country versus another and the price action of the currency pairs. But theoretically, a rising yield differential for a country tends to draw in hot money global capital, thus having a self-reinforcing effect on a currency.
Over the longer term this can become a very positive feedback loop as a rising yield differential often represents a rising growth prospect for a country; thus not only is short-term hot money drawn in, but longer term foreign direct investment may flow to the country to position for longer term capital gains. This has been part of my rationale for why the US dollar is in a longer term bull market. But at the moment, that rationale is being challenged a bit and it does throw a little monkey wrench into my last missive about pending euro weakness.
Presently, there is a fairly tight correlation between the rising 2-year benchmark spread in favor of the Eurozone compared to the US and the path of the euro (EUR/USD).
We can all conjecture till the cows come home as to why this spread may be moving in the eurozone’s favor, e.g. new Fed Chairman Janet Yellen will be more dovish than expected or there is a real recovery underway in Europe. Or maybe it’s a combination of both. We don’t know. But that doesn’t mean monitoring this spread is worthless.
The fact of the matter is this: both the yield differential and currency are moving upward together. For longer term trend players this generally means you shouldn’t be short EUR/USD in this environment and for those long it means you should stay that way. I think this is one way monitoring these relationships can increase your chances of success. Keep in mind longer term players.
But, even those whose trading time-frames are shorter I think can still benefit from monitoring the yield spread.
It’s not about projecting trends and correlations into the future: For example, if there is a consensus expectation the Fed will taper sooner rather than later because of last Friday’s better than expected non-farm payroll reports, that stuff is likely already in the price. It is about knowing the trend and watching to see if the consensus is surprised.
One such surprise might be if Janet Yellen tells the assembled masses she prefers the US Participation Rate over the Unemployment Rate as a better measure of the strength or weakness of the US job market and therefore has decided it is much too risky to consider tapering now that victory is close at hand. Such a surprise would likely lead to a wider yield spread in favor of the Eurozone and might also lead to yet another leg up in EUR/USD.
The thing is, as traders, we shouldn’t expect that from Mrs. Yellen. We should just build plausible scenarios that are different from market expectations, and watch as reality crashes against said expectations. I believe this kind of scenario/neutral type of thinking will give the confidence to move more quickly than most of the other players, or reposition accordingly.
It may be a surprise to many that yield spreads are moving in favor of the Eurozone compared to the US. But it is what it is for whatever reason. As a trader, I think it is important to accept that fact instead of getting tied up in explaining it. Let’s leave that stuff to the economists who can usually tell us the reasons with the utmost precision as soon as things change and rationales become “clear.”
I guess if there is a moral to this interest rate missive today, it is this:
“You don’t need to know what is going to happen next in order to make money,” said Mark Douglas in his great book, Trading in the Zone.
It might be best to let Mr. Market tip his hand a little before the big bets are placed. And a focus on yield spreads is a good place to watching for a tell.