By Dean Popplewell
The forex market relies on interest rate differentials to raise market volume and volatility, twin properties that seem to be lacking ever since central banks began to handcuff capital markets with their "looser" monetary policies. A "lower interest rate for longer policy" by most G7 policy makers has maimed forex interest, promoted global bourse trading to a questionable height and severely cut fixed income returns. The possibility of an end to a low rate environment will promote further forex market interest. Under the current rules of engagement - low rate, little volume - the "carry" trade continues to reign.
The mighty USD needs higher yields to outperform - dealers thought we were getting that, especially after the uptick in last month's CPI release last week, the fastest one month gain in two-years (+0.4%, m/m, and +2.1%, y/y). Nevertheless, Yellen and company flatfooted the market by not being aggressive at the last FOMC meet and seem content to continue the low rates for longer policy.
However, stronger US data (home sales, employment numbers and projected short-term growth) have the fixed income dealer trying to push the US curve back, but there remain a few obstacles in the way for higher US Treasury yields over the short-term.
- Emerging Markets looking stretched;
- European Periphery are beginning to look rich relative to the core-curve; and
- Sizeable bond redemptions in Europe are to head into Germany/France.
Asian appetite for euro paper, particularly periphery, has managed to tighten the bund/periphery spread aggressively, so much so that Spain, Italy and Ireland have all traded through the US curve at one time or another. By default and indirectly, Asian appetite has supported the single unit (€1.3600) to an extent. Currently, it seems accounts are getting a bit wary of how tight euro spreads are again. This has instigated some decent selling interest of Emerging Market ETFs at their multi-year highs, with investors happy to take some profit on longs as well as initiating new "shorts" up at these levels.
The market's general view is that "peripheral" (Spain, Ireland, Italy, Portugal, Greece etc.) spreads have run their course for the time being and that everything is looking a bit stretched. If investors are looking for yield, perhaps taking on more "duration" risk is a safer and smarter strategy at these spread levels than taking on more "credit" risk. By selling Spanish 5-years and buying German bunds, investors maintain the same "safe credit" and pick up similar yield. This scenario will provide headwind for further euro periphery tightening. US yields will be dragged down by higher bund prices as their spreads begin to narrow.
Also a potential impediment to higher yields is the fact that a plethora of redemptions get to hit the street in Europe. It has been estimated that €52b worth of capital will be returned to European investors in the form of bond redemptions at the beginning of next month. Where will investors consider putting this cash to work? Due to the reason outlined above - stretched EM and credit risks - many expect that most of this cash will be redeployed into the core and semi-core - namely Germany and France, and most of this in the 5 to 10-year buckets (duration). This should widen the spread between bunds/Treasuries (10s, +130), certainly to levels that look increasingly appealing for the global investor. The general flow into USTs out of Europe from more actively managed funds continues, especially now that US 10s have found some stability in the low +2.60%. A decent bid for German product will slow a US curve backup and destroy the market's overwhelming interest to want to own dollars.