In “2-Year Yields Highest Since 2009 While German Yields Argue With Soaring Inflation,” I said the following with regard to rate differentials in light of 2Y yields hitting their highest intraday levels since 2009:
[This should] certainly lend credence to the structurally strong USD story.
As the Wednesday session wore on, the dollar lost a bit of its luster and although this is one of those times when we should probably avoid our natural tendency to ascribe causes where there are none, traders may already be questioning themselves with regard to how aggressively a March hike is now priced.
“Trader attention is now turning to Yellen and Fischer for their views on rate-hike expectations,” Bloomberg wrote this afternoon, adding that the market is now “pondering the next move.”
Well, while you’re pondering, you might want to consider the quoted passage from this morning’s piece. That is, regardless of whether you agree with how the market is now pricing the odds for a March hike, you should think about the extent to which policy divergence between the Fed and the BoJ/ECB is for all intents and purposes inevitable. That, in turn, means that you should think seriously about what widening rate differentials mean for the greenback going forward.
For more on this, we go to Goldman.
Via Goldman
The USD is prone to a quick upside repricing if the FOMC were to hike the federal funds rate in March. Even though the market updated quickly the probability of a March hike, the pricing of the cumulative increase in the federal funds rate over the next 2 years has not changed much, and is still 100bp below the path of our US economists’ forecast. We would expect a March hike to lead the market to price two additional hikes in 2017 and three hikes in 2018. In the second half of the year, if data remain solid, the market could price four hikes over the following twelve months. As we have often discussed, the 2-year interest rate differential is what matters most for the currency and, based on our interest rate differential model, a 100bp increase in the 2-year USD interest rate translates into a USD appreciation versus G10 currency of about 10 percent.
