Weekly Chart: Cable vs. 2Y UK – US IR Differential

As for EURUSD and the 10Y interest rate (IR) spread (here) or for USDJPY versus the equity market (TOPIX, see here), the same interesting divergence has been occurring between Cable and the 2Y IR differential. We mentioned in many of our posts that the interest rate differential (either short term 2Y or long term 10Y) has been considered as one of the main drivers of a currency pair for a long time. For instance, in our BEER FX Model, we used the terms-of-trades, inflation and the 10-year interest rates differentials for our cross-sectional study, using the US Dollar as the base country and currency (see post here).

Hence, if you look back over the past few years, there is a significant co-movement between the two times series. As you know, the ST 2Y IR differential reflects the expected announcements from either UK or US policymakers concerning the future path of the target IR set by the central bank. For instance, between summer 2013 (when Governor Carney took office at the BoE) and summer 2014, the 2Y IR differential went up from 0 to 45bps on the back of strong UK fundamentals (fastest growing economy in G7 in 2014) and market participants starting to price in a rate hike as early as Q4 2014 or Q1 2015 according to the short-sterling futures contract (see July 2014 update). The increase of both the 2Y IR differential and the short-sterling futures implied rate brought Cable to its highest level since October 2008 at 1.72 in July 2014. However, both trends reversed that summer with the US Dollar waking up from its LT coma and the UK starting to show some weaknesses in its fundamentals. At that time, we entered a 2Y+ Cable bear market, and if we omit the pound ‘flash crash’ in early October 2016 and set the low at 1.20, Cable experienced a 30-percent depreciation. Therefore, this fall moved the British pound from being a slightly overvalued currency to a clearly undervalued currency if we look at some broad measures such as the real effective exchange rate (REER). According to the REER, the Pound is 15% far away from its 23Y LT average (GBP REER).

If we look at the last quarter of 2017, despite a 50bps drop in the 2Y differential (currently trading at -1.44%), Cable found support slightly below its 100D SMA each time and the pair has shown strong momentum since the beginning of the year. We believe that the strong decrease in the IR differential lately comes from an (over) confident market pricing in three Fed hikes next year (probability of 4 or more rate hikes stands at 9% in 2018). However, we think that this current excitement may slow down in Q1 2018, hence readjust the IR differentials, which is going to be positive for the British pound against the greenback. In our view, the 1.40 level seems reasonable for Cable in the medium term (1-3M), which corresponds to the 38.2% Fibonacci retracement of the 1.20 – 1.72 range.

Chart: GBPUSD vs. 2Y IR differential (blue line, rhs) Source: Reuters Eikon

Cablevs2Y.PNG

Weekly Chart: US 2Y10Y yield curve vs. USDJPY

Among all the potential compatible candidates that show an interesting correlation vis-à-vis the USDJPY (i.e. 10-year US-Japan interest rate differential, Topix index …), I chose this week to overlay the currency pair with the US 2Y10Y yield curve. If we look at the past three years of data, we can notice an interesting development that has started since mid-April of this year. While the US yield curve and USDJY has shown strong co movement between January 2015 and April 2017, it has been a different story over the past 8 months.

In the US, the yield curve has constantly been falling and is currently trading at 51.5bps half the value where it was sitting in April 2017. On the other hand, the Japanese Yen has been oscillating within a 7-figure against the green back, between 107.50 and 114.50. What is interesting about this divergence is that it started more or less at the same time of the Topix vs. USDJPY divergence, with Japanese equities soaring from 1,500 to 1,800 and a Yen mean reverting around 111 against the USD ( see tweet Topix vs. USDJPY).

The question now is: How long can this divergence persist in the near to medium term? The current level of the US yield curve has raised the concern of many market participants as in theory it is viewed as a strong predictor of future recessions. Looking at economic and financial data, I don’t personally believe that we are very close to a potential recession in the US; in addition, the yield curve is still far from its extreme lows of -20bps and -95bps we saw in November 2006 and May 2000 (if we just look at the past 30 years of data). However, I think that we may see some US Dollar weakness against the Japanese Yen, on a back of slowly disappointing fundamentals (easing all the excitement on the expected Fed rate hikes) and geopolitical uncertainty. Moreover, the Japanese Yen is 26% ‘undervalued’ relative to its 23Y average of 99.3 according to the real effective exchange rate ( see JPY REER).

Chart: USDJPY (Candlesticks, rhs) vs. US 2Y10Y yield curve (Source: Bloomberg)

JPY US Curve