In recent months there has been a lot of confusion, and loud gnashing of teeth, among the FX trader and analyst community, which has been unable to make sense of the confounding divergence in real spot rate differentials charts between the EUR and USD, whether on the short or long end.
Making matters more confusing has been the sharp jump in the EURUSD in recent weeks, a paradox in light of the progressively improving US economic data.
And so, traditionally used to trade on correlation pairs, the forex community set forth to find a new, improved, and more accurate correlation between the EURUSD and… well, anything. Today, Bank of America appears to have stumbled on the answer in the form of the EURUSD vs. relative forward interest rate expectations, and specifically the EUR-USD 2y2y-2y forward spread differential.
The reason why this particular forward rate differential is best suited to capture the fate of the EURUSD is that it looks not at the current pricing of real rates, but future central bank interest rate expectations, especially those of the ECB and BOJ which over the coming year are increasingly expected to slam the breaks on both QE and NIRP.
Here is how Bank of America’s FX research team lays out the background:
Pressure on the dollar has intensified in the opening weeks of the year despite a supportive macro backdrop. US data had had a strong run, fiscal stimulus is expected to provide further tailwinds to the already-solid growth outlook this year and the Fed continues to tighten. Yet the synchronized global recovery is focusing market attention on other major central banks. As we have argued before, the USD traditionally benefits from first-mover advantage as the Fed leads other central banks into a global tightening cycle. That was the primary driver of dollar appreciation in 2014-15. However, as other G10 central banks follow the Fed’s lead, the USD has been faltering despite ongoing tightening. This is because interest-rate expectations outside of the US have undergone a profound shift. With respect to EURUSD specifically, relative forward interest-rate spreads explain the sustained rise in the exchange rate since early 2017, though upside looks limited for now.
And here is what the relationship looks like in particular, as shown in BofA’s “chart of the day”:
Clearly on a backtest, the 2y2y-2y forward spread captures the EURUSD moves far more accurately than a simple real spot delta (as seen up top). In other words, instead of using spot rate differentials, the proper metrics is a “forward” based framework for exchange rates.
Here Bank of America explains why spot rate differentials no longer work:
The fundamental link between global central bank repricing and USD-based exchange rates (emphasis: EURUSD) cannot be seen through the traditional lens of spot interest rate differentials, which have broadly continued to move in a direction favorable for the dollar. Indeed, the US two-year swap rate has risen a full 65bp from levels prevailing in early September (for reference, only the CAD 2y rate rose by more).
Instead, the FX strategists caution that “FX markets are in a regime defined by interest rate expectations.”
So while the EUR 2y swap rate has increased by a mere 8bp over this period, the EUR 2y2y-2y forward spread has steepened by nearly 30bp, most of which since early December. Conversely, the US 2y2y-2y forward spread has remained essentially unchanged, if not marginally flatter, reflecting expectations of a reduced pace of Fed tightening ahead, potentially representing entrenched beliefs regarding the maturity of the US economic cycle.
This is where BofA’s delightful chart of the day comes into play:
Our Chart of the day: EURUSD vs. relative forward interest rate expectations shows EURUSD plotted alongside the EUR-USD 2y2y-2y forward spread differential, which measures the amount by which the market expects the EUR-USD 2y spot differential to move over the next two years. We think this is a convincing framework to assess EURUSD from the standpoint of monetary policy divergence as it focuses on expectations. Over the last year, the shift in this differential has been large at about +100bp, roughly coincident with the shifts in relative EUR-USD growth during this cycle. Specifically, the market went from pricing a 60bp decline in EUR-USD 2y rate differential over a two-year horizon to presently pricing in a 40bp rise (hence the 100bp delta). EURUSD has tracked the 2y forward curve differential closely, with daily changes in the latter explaining nearly 30% of changes in the former and justifying the 15% EURUSD rally since early 2017.
So if the EURUSD is trading on future expectations of what Mario Draghi will do, here is what the fwd rate differential implies at this moment:
While the October ECB meeting had provided a sense of medium term stability for ECB policy, comments from Coeure on 21 November questioning the open-endedness of QE kick-started a repricing of EUR front-end rates. In our view, it was precisely the open ended nature of QE, and the ECB’s ambiguity around the program’s end date, that had, up to then, acted as an anchor for short term rates, the two being linked by the ECB’s commitment to keeping rates at their current levels “well past” the end of net asset purchases, which the market had been interpreting as a six-month period.
Mid-December saw an extension of the front-end selloff as the December ECB meeting provided little additional information. However, it was the release of that meeting’s minutes last week that triggered the most significant moves. More specifically, reference to the fact that a “gradual shift” in forward guidance may be warranted by early 2018 appeared to catch the market off guard. The result was a sharp move in rates, driven by 5s, but also affecting the very front end. Specifically, the market now prices in a 70% chance of a 10bp hike in the Depo rate as early as December 2018, and Eonia forwards imply the Depo rate would be brought back to zero by December2019.
The change in tone in the December ECB minutes has admittedly come earlier than we had anticipated. We expected the shift in emphasis in forward guidance from QE toward policy rates to provide support for EURUSD in the second half of the year.
Of course, the flipside is that if the EURUSD can soar by 300 pips just on one ECB phrase, it can also plunge as much if not more, as soon as next week if Draghi decides to pull another Sintra and retracts the Minutes’ hawkishness, which could send the EURUSD tumbling, for two reasons: the EURUSD is now far above the ECB’s recent “redline” of 1.20, and second, as BofA notes, “to the FX markets, this shift in emphasis seems to have effectively consigned the ECB QE era to history, marking a return to a more conventional policy approach.”
While this is a very important point because as we first showed some 5 years ago…
… historical correlations that have driven the EUR have been distorted by the ECB QE-wedge. A return to a conventional policy setting offers the prospect of a reversion back to these historical correlations which broke down in 2015. Moreover, the impact is likely to extend beyond the EUR, specifically, and to currencies whose central banks have implicitly pegged their own policy to the ECB.
… we very much doubt that the ECB’s QE is over, especially once the hundreds of billions of European fixed income products which have traded entirely by frontrunning the ECB, tumble and fall, unleashing the next European financial crisis, this time directly affecting corporate credit (see Steinhoff), crushing an army of European zombie companies in the process, and leaving millions without a job.
Said otherwise, fear not eurodoves: Draghi will soon find an excuse to keep QE going for a long time, even – or rather especially – if it means monetizing equities next.
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Finally, here are some parting observations on the forward rate differential, and how it compares to spot as well as relative growth.
The EUR-USD 2y2y-2y curve differential is now at the highest since the global financial crisis and is approaching 2005-06 extremes, a period in which it reached +50bp (Chart 3). We think that the 2005 analog is instructive regarding the empirical upper bound on relative 2y2y-2y rate expectations. Assuming the market retests the +50bp level (another 10bp from here), we think this should translate to only modest (roughly 2%) higher EURUSD, ceteris paribus. This means we are approaching limits to long EURUSD predicated on ECB normalization expectations.
From a narrow standpoint of relative monetary policy, a sustained EURUSD move above 1.25 probably requires spot interest rate differentials begin to move higher, as they ultimately did in 2H06, roughly two years after the Fed initiated its first interest rate hike and after a lengthy (one year) bottoming process. Incidentally, this was driven by a sharp (-3%) decline in US inflation, which we think is highly unlikely anytime soon. It is also worth noting that back in 2005, unlike now, the EUR-USD growth differential was highly negative at about -2%. It ended up rebounding strongly over subsequent years, supporting a sustained rise in EURUSD to 2008 highs (Chart 4). At present, however, this growth differential has already surged higher into positive territory (relatively rare historically). Note that our current economic forecasts point to a reversal-not an acceleration-of the current EUR growth advantage.
So does thie mean that legacy rate differentials no longer work? Not at all, in fact it’s just a matter of time before it becomes relevant again: as BofA concludes, the EUR 2y spot interest rates should ultimately rise over the longer term.
“A simple comparison to the US at this point in 2014 (10 months before the end of QE) suggests upside potential could be 50-100bp over the next two years (Chart 5), even as rate expectations (using 2y2y-2y) begin to soften (Chart 6).”
Obviously, conditions in the Euro Area are different to those of the US back in 2014, but the context may be helpful. The more relevant question is what happens to the EUR-USD spot interest rate differential, because this will at some point over the next one to two years re-emerge as the relevant monetary policy variable for EURUSD, as the expectations channel wanes in importance. On this subject, we think that upside in USD 2y rates could well match, and probably exceed, that of EUR 2y rates, particularly over the near term.
That said, in light of this new framework of evaluating the common currency – if only for the near future – what will happen to the EUR-USD spot interest rate differential is less important than what happens to the forward one, the one which determines what the EURUSD will do for the foreseeable future. We will unveil what BofA’s believes the answer is shortly (spoiler alert: dollar bulls may finally be happy).
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