• Fundamental evaluation series: EUR/USD vs. 2-year yield spread

    Source: FxWire Pro - Commentary / 25 May 2018 09:05:10   America/New_York

    The chart above shows, how the relationship between EUR/USD and 2-year yield divergence has unfolded since 2012. It is evident that these short rates have been a key influencing factor for the pair as policy divergence became evident since 2013.

    Past divergence and move in the exchange rate:

    • As the speculations of Federal Reserve's withdrawal from extraordinary monetary stimulus became frenzy since the beginning of 2014, yield divergence between German 2 year bond (considered as European benchmark) and the US 2 year note went from -0.18 percent at the beginning of 2014 to -0.78 percent by the end of the year and EUR/USD declined from 1.367 to 1.2 by year-end.
    • We saw further drop in the EUR/USD exchange rate in 2015 as ECB introduced monetary stimulus but the yield failed to follow that fast. It only started declining as the expectations for further stimulus grew and by end of December, declined more than 50 basis points compared to the first quarter of 2015.
    • European Central Bank (ECB), however, disappointed in December 2015 and only to deliver in March 2016. Since December, Germany-US yield divergence has moved in a range lacking clear direction as the Fed became more cautious than expected. So had the EUR/USD.
    • From summer last year, the yield spread has started declining again and after Donald Trump won the US presidency, the spread has widened sharply. In August, the spread was at 1.35 percent and it deteriorated to -1.43 percent just before the US election and in December it reached -1.87 percent. Similarly, the euro has declined from 1.11 against the dollar, prior to the election to 1.065 in December
    • In a review in February, we discussed that the yield spread has widened further by almost 20 basis points. However, the exchange rate hasn’t followed through, and we pointed to the divergence building up.
    • In our review in May, we noted that while geopolitical factors are playing a key role in influencing EUR/USD, the yield spread is also playing its part. The recent spike in the EUR/USD exchange rate coincided not only with the French election outcome but a narrowing of the spread too.
    • In our review in June, we pointed that the spread has narrowed by only by 5 basis points, while euro has moved up against the dollar by more than 250 pips, pointing to a divergence, which means that there could be a correction in the euro against the dollar or in the bond spread.
    • In our review in July, we noted that the divergence between the exchange rate and the yield spread has widened further. Since the June review the spread has widened further by 10 basis points in favor of the dollar, however, the euro has gained more than 400 basis points against the dollar.
    • In August, we noted there have been no major changes both in terms of spread, which was then trading at 205 basis points in favor of the USD and the exchange rate which was at 1.177.
    • In Mid-September review, we noted that the divergence between the exchange rate and yield spread has widened further. Since August 13th, the spread has widened by almost 10 basis points in favor of the dollar, while the euro has gained 230 pips against the dollar.
    • In our October review, we pointed out that the European Central Bank (ECB) issued forward guidance that the central bank would further taper the amount under asset purchasing program from €60 billion to €30 billion once the current program expires in December. It extended the program until September 2018 and the spread has further widened by 19 basis points to 234 bps in favor of the dollar, while the euro has declined by 310 pips and to 1.164 against the USD.
    • In our last review in November, we noted that the spread has further widened by almost 13 bps in favor of the dollar to 247 bps, while the euro strengthened by 100 pips, leading to higher divergence.
    • In our mid-December review, we noted that the spread has further widened by 6 basis points to 253 bps and the euro has somewhat weakened by 100 pips thus reducing the divergence. The divergence in the euro is still quite large.
    • In our January review, we noted that the spread has further widened by 13 bps to 266 bps in favor of the dollar, while the euro has moved higher by more than 620 pips against the dollar and was trading at 1.247.
    • In February review, we noted that the spread has further widened by 11 bps to 277 bps in favor of the dollar and the euro has declined by 150 pips to 1.232 against the dollar.
    • In our March review, we noted that the spread has further widened by 12 bps to -289 bps in favor of the dollar, while the euro strengthened by 80 pips to 1.24 against the USD.
    • In our April review, we noted that the spread has further widened by 15 bps to 304 bps, and the euro declined sharply from 1.24 to 1.208 thus reducing the divergence.

     

    Since that review, the spread has further widened by 11 bps to 315 bps and the euro declined further to 1.167 as of today. The divergence is getting reduced fast.

    However, the divergence visible in the chart is still quite large, which increases the risk of a further correction. 

    As central banks around the world on the verge of reversing stimulus, we highly recommend regular watching of the spread.  

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