Policy convergence is a hot-topic these days, as hawkish comments from central bankers outside of the US and a relatively more benign econ backdrop in Europe have led markets to anticipate that the disconnect between Fed policy and ECB policy could begin to close. More simply, it’s looking likely that the UST-bund spread could narrow and further underpin the euro.
In that regard you kind of have to think there’s a lot of room for compression because let’s face it, bund yields are still absurdly low despite last week’s doubling and Treasury yields have had an awfully difficult time breaking sustainably to the upside as the nightmare in Washington has capped expectations for tax reform, fiscal stimulus, and really, this administration’s entire agenda.
The Fed is hiking but, a recent bout of steepening notwithstanding, the curve is getting flatter, which probably doesn’t presage anything good for the US economy.
Well, as we kick off H2, SocGen’s Kit Juckes has some thoughts on all of that and more, which we thought we’d share below…
Transatlantic economic and yield convergence dominated the first half of the year and the FX market mirrored that move with the euro near the top of the rankings, against the US dollar near the bottom. In fact, the euro wasn’t the top of the currencies – that prize went to the recovering Mexican peso, followed by a selection of ‘euro-alternatives’, PLN, CZK, ISK and ILS. Nor was the dollar the worst of the bunch, with COP, BRL and ARS under-performing. But still, in a 6- month period when US yields fell, European ones rose, and Japanese ones did nothing, it was the EUR/USD move that caught everyone’s eye. We saw stronger equities and softer oil prices too.
Thinking about where the peak will be in 10-year Treasury yields last week, I pondered the fact that the peak has usually (in my working life) come at roughly the same level (but not quite at the same time) as the peak in the Fed Funds rate. 1994 is the odd cycle out here, but it was odd in more ways than that so I won’t dwell on it. One of the things we hear discussed a lot is that an inverted yield curve tends to be a good predictor of recessions, but that’s because it comes at the same time as peak Fed Funds, and ‘peak tight money’ is a good predictor of recessions for more obvious reasons. But what that means is that as a really, really simple rule of thumb, the current level of 10-year note yields approximates as the market’s guess of where peak Fed Funds will be. And as we have seen them manger between 2.1 and 2.7% this year, the market has displayed uncertainty around a central theme – the 3% long-term median dot in the Fed’s projections is too high. We’ll see what we think after the FOMC minutes, wage growth and the early signs of June economic activity, but my guess is that we are in for more meandering.
Since the latest CFTC data suggest the market is short USD and building its long EUR position again, while yield differentials suggest the dollar’s a bit oversold, maybe the market’s thinking about Fed meandering is enough for a pause in the sell-off?
I don’t think one should extrapolate the point of peak policy rates and bond yields too far, but even after a dramatic rise, the current 46bp Bund yield looks low on that basis. As the monetary policy cycle turns, albeit slowly, there’s more upside to long-term ECB rate expectations and to Bund yields. Throw in the undervalued currency and the ingredients are still there for more euro upside in due course. Also, perhaps, for more upside in the other European currencies, which may include some catch-up for NOK and SEK, relative to the sexier ones that dominated H1.