The euro has risen almost 2% against the U.S. 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 December to 35 bp last week. The yield rise in the December '13 contract has been even more pronounced. In early December, 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 for a 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 of these considerations is that the U.S.-German 2-year spread, which historically tracks the euro-dollar exchange rates, has collapsed. In early December 2012, at about 32 bp, the U.S. 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 U.S. 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 from 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 U.S. 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 U.S. 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 U.K. offers over Germany on 2-year money is below 8 bp, the smallest since December 2011.
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