This page has been archived and commenting is disabled.

The Explanatory Power of Interest Rate Developments

Marc To Market's picture




 

The euro has risen almost 2% against the US dollar thus far this year, while the yen has fallen about 4.5% against the greenback.  Beneath this divergence may be a common consideration:  Interest rate developments. 

One of the key developments has been the steep backing up of short-term European interest rates.  Consider that the implied yield on the March Euribor 13 futures contract has risen from about 10 bp in early in Dec to 35 bp last week.  The yield rise in the Dec '13 contract has been even more pronounced.  In early Dec, the implied yield was about 11 bp.  Now it is near 56 bp.

It is important to note that the increase in yields began at the end of last year and has accelerated this year.  It is being driven by at least three considerations.  First, this may be partly a reflection of less need to safe haven.  There has been a transformation of the main guiding principle from capital preservation to taking on more risk. 

Second, European banks have been borrowing less from the European Central Bank.  The ECB's balance sheet was shrinking even before the European banks repay part of their LTRO borrowings.  Third, the repayment of the LTRO funds was greater than expected at 137 bln euros.  If the borrowings from the second LTRO are repaid in similar proportion, the ECB's balance sheet will shrink another 148 bln euros next month.  Of course it is possible that the banks simply shift some funding from the long-term repo to shorter-term refinancing from the ECB and the weekly operations will be closely monitored. 

One of the consequence these considerations is that the US-German 2-year spread, which historically tracks the euro-dollar exchange rates, has collapsed.  In early December 2012, at about 32 bp, the US was offering the largest premium over German on 2-year money in four months.  It is now flirting to move into Germany's favor.    Over the past 30 and 60 day periods the euro and the 2-year rate differential move in the same direction about 71% of the time. 

The 10-year interest rate differential between the US and German has also moved toward Germany.  The US was offering a 44 bp premium at the end of last year and less than 30 now.  Over the past 30 days, the correlation with the euro and the 10-year interest rate differential is as high as the correlation with the 2-year differential.

What about the weakness of the yen?  Is it simply rhetoric, or do interest rate developments also help explain what is happening?  The 2-year premium over Japan has increased 15 bp the end of 2012 to over 20 bp today., which is the upper of the eight month trading range.  

Just as striking has been the widening differential at the long-end of the curve.  At the end of last year, the US offered about 90 bp more than Japan and now it is offering more than 120 bp. The correlation between the dollar-yen and the 10-year differential is just below 0.90.

The widening of the interest rate differential is largely a function of the increase in US 10-year yields.  Thus far this year, the 10-year Treasury yield has risen 21 bp compared with a 4 bp decline in the 10-year JGB.  We remain struck by how well Japanese government bonds have performed in the face of the yen's depreciation.  While there has been some steepening at the long end (10 yr-30-yr), since the start of the year and for the past three months, Japan's 10-year yield has matched the yield decline seen in the 2-year. 

By extension, interest rate differentials may also help explain the euro's strength against the yen.  In addition, the same consideration is bolstering the euro against sterling.  The premium the UK offers over Germany on 2-year money is below 8 bp, the smallest since Dec 2011.

 

- advertisements -

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Mon, 01/28/2013 - 13:01 | 3191698 Orly
Orly's picture

Okay...

Well, anyways, the Cable has breached the lower trendline of the Weekly wedge that I mentioned some weeks ago.

A reversal is imminent.

:D

Mon, 01/28/2013 - 12:24 | 3191543 Orly
Orly's picture

"The premium the UK offers over Germany on 2-year money is below 8 bp, the smallest since Dec 2011. "

Does this explain the severe weakness in the Sterling, especially against the US Dollar?  Or is it a balancing act to not skew the DXY?

Also, with bonds pricing in a "Mission Accomplished" scenario, how does this bode for rates when and if equities come off, as they push the exuberance needle toward the irrational level?

If a greater fear returns to the markets, through some unknown catalyst, what will be the character of the Japanese yen?  Does it retain the safe-haven status that it has had over the past several years , or does it become a "risk" currency and get sold off?

:D

Mon, 01/28/2013 - 12:41 | 3191619 Marc To Market
Marc To Market's picture

Is 2% yield on US 10-year bond "Misson Accomplished"? 

Mon, 01/28/2013 - 12:06 | 3191477 Herkimer Jerkimer
Herkimer Jerkimer's picture

'

'

'

The fed isn't going to raise the rate because of that little 16-17 trillion dollar debt.

They can barely afford the vig right now.

 

•J•
V-V

Mon, 01/28/2013 - 10:35 | 3191152 mightycluck
mightycluck's picture

I found this on the internet. A good discussion of why interest rates may not rise as fast as some think.

http://confoundedinterest.wordpress.com/2013/01/27/1994-redux-will-treas...

Mon, 01/28/2013 - 11:24 | 3191307 TotalCarp
TotalCarp's picture

Very good link, thank you cluck

Do NOT follow this link or you will be banned from the site!