The Yield Differential Between Treasuries And Bunds Favors A Stronger Dollar

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Includes: ERO, FXE, UUP
by: Jasper Lawler
Summary

The 10-year yield differential between German bunds and U.S. Treasuries is continuing to move in favor of the U.S.

The spread between U.S. Treasuries and bunds is correlated to the movements in the EUR/USD.

Policy divergence: The ECB has said interest rates will remain on hold until mid-2019, while the Fed has upped its guidance to four rate hikes in 2018.

The dollar is stronger in the wake of the ECB and Fed monetary policy decisions. While the Fed increased interest rates by 25 basis points and struck a hawkish tone, the ECB announced the phasing out of their quantitative easing plan. The key to the ECB statement was that interest rates will remain on hold until mid-2019, squashing any ideas that the ECB will begin to raise rates. The 10-year yield differential between bunds and U.S. Treasuries is continuing to move in favor of the U.S. which should weigh on the currency pair and buoy the greenback.

Yields Differential

The spread between U.S. Treasuries and bunds is correlated to the movements in the EUR/USD. The yields make up the forward curve and therefore, plays a role in determining the forward rate of a currency pair. As the yield in treasury bonds become more attractive relative to bunds, investors will purchase the dollar to gain from the yield difference.

(Chart Source: StockCharts.com)

The European Central Bank Confirms Phasing Out Of Quantitative Easing

The ECB confirmed that quantitative easing will end in December of 2018, but interest rates are to stay on hold at least through summer of 2019. The central bank said that asset purchases will run at the current schedule of EUR 30 billion per month to September, monthly purchase volumes will then be reduced to EUR 15 billion and end in December. Mario Draghi also confirmed that the stock of assets will be maintained for an extended period. The key focus was on the guidance on rates as Draghi sent a dovish signal that squashed speculation that the early commitment to a phasing out of QE would also mean early rate hikes.

The Federal Reserve Increased Interest Rates As Widely Expected

The FOMC increased the Federal Funds rate by 25 basis points and announced an uptick in its dot plot forecast to 4 interest rate increases in 2018. Additionally, the Fed cut out its reference to the funds rate 'remaining low for an extended period'. The statement also indicated the labor market continued to strengthen and economic activity has been rising at a solid rate. The Fed basically repeated that both overall inflation and inflation for items other than food and energy have moved close to 2% while longer-term inflation expectations are little changed.

Despite a more hawkish tilt in the FOMC's forecasts, Chairman Powell had a balanced tone. He again discounted some of the messages in the dots, saying the individuals' estimates really hadn't changed much, while none of the tweaks in the forward forecast signals policy views. He also noted that the Fed's models aren't showing a spike in inflation pressures.

Inflation In Europe Is Confirmed At Elevated Levels

Inflation data in Europe remains stable but elevated. German May HICP was confirmed at 2.2% year over year as expected. Data showed no surprise with headline readings all confirmed in line with preliminary numbers, leaving the annual rate now above the ECB's upper limit for price stability. Higher oil prices are partly to blame, with annual rates for heating oil jumping to 7.6% year over year from 5.4% year over year in the previous month.

With the Fed raising rates and the ECB keeping rates unchanged until mid-2019, the divergence in monetary policy is widening again. This should put downward pressure on the EUR/USD currency pair and allow the interest differential between Treasuries and bunds to widen.

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