The day of the commodity currencies! AUD, CAD and NZD led the ranks. Meanwhile USD fell even though US interest rates continued to rise, hitting a new high for this economic cycle.
In contrast to Tuesday, the higher US yields didn’t derail the US stock market, which managed to close higher – possibly because of a better-than-expected US industrial production figures. Higher bond yields due to stronger economic activity are a different matter to higher bond yields because of higher inflation. Housing starts disappointed but the forward-looking permits were better than expected.
It looks like Italy’s problems are starting to have an effect on the markets. Not only are the two parties are still struggling to reach agreement on forming a coalition, but one of the points they seem to be discussing is whether to ask the ECB for debt forgiveness. Greece was bad enough, but Italy is the largest bond market in Europe, with EUR 2.4tn in bonds outstanding. One politician said they are discussing an EUR 250bn write-off, although another politician denied it. Would that be enough, or just the first step? They are also reported to be discussing the renegotiation of European treaties, reform of the Stability & Growth Pact, and a revision to Italy’s budget contribution. Italian yields jumped and most peripheral bond spreads ended the session at their wides for the day, aided by a “flight to quality” within the EU that saw 10yr Bund yields decline 4 bps.
However, German Chancellor Merkel in effect rebutted these ideas. Noting that the ECB’s loose monetary policy won’t last forever, she called for more integration of the Eurozone economies, saying: “the global view of joint currency unions states that you need to have some kind of element of last resort.” This could be a hint of measures to be discussed at the EU summit on 28-29 June.
Given the tumult in Europe and the rise in US yields, it’s surprising to me that USD weakened vs EUR. Especially, the UST/Bund yield spread is now the widest it’s been since the inception of the ECB. I don’t think this is a tenable situation, particularly since Bund yields are negative out to 5 years – how “safe” is an asset that you’re guaranteed to lose a little money in, as opposed to one that you might lose a lot of money in? I would expect USD to recover in short order.
The good performance of stock markets, plus the successful rollover of some Argentinian short-term notes sparked a general risk-on tone and a relief rally in emerging market currencies.
GBP gained after the Telegraph newspaper reported that the UK will tell the EU that it’s prepared to stay in the customs union beyond 2021. My question is though, will that be acceptable to the hard-core Leave faction in the Cabinet? It seems to me to be “Brexit-lite,” leaving the EU in name but not in reality, as remaining in the customs union also means adhering to various EU rules and regulations without having any say in their making. I’m not sure this is going to fly politically in Britain. It may settle one problem, but set up another one – a Cabinet revolt.
NZD was up after the government raised its forecsats for the budget surplus for the fiscal years out to 2020. AUD/NZD continued to rally nonetheless as Australia’s employment data beat expectations – total employment was more or less in line with expectations (+22.6k vs +20.0k expected), but the mix was excellent – full-time jobs +32.7k, part-time -10.0k. The unemployment rate rose but that was due to a rise in the participation rate, which is a good sign. Given the longer-term headwinds to NZD, I think AUD/NZD can continue to rally somewhat.
Impact of US yields on currencies
Yesterday I discussed which currencies moved the most in response to higher US Treasury yields. Today I’d like to examine this issue a bit more and see exactly what’s behind these moves: the change in nominal yields, the change in real yields, or the change in inflation expectations.
I’ve taken a longer-term view here and looked at the weekly correlation over the last two years.
The results are clear: the dollar tends to strengthen both when nominal yields (Treasury yields) or real yields (TIPS) go up, and also when US inflation expectations (breakevens) rise. The strongest correlation is with nominal yields, then with real yields. Ignoring all correlations with an absolute value of less than 0.1, there is no example of a significant correlation that’s stronger for TIPS than for nominal yields. There are only a few cases where there is a significant correlation and it’s higher for breakevens than for TIPS, but even then it’s only a small difference (none is higher than for nominal yields). And perhaps most significantly, the signs are the same for all three measures, meaning a rise or fall in any of them tends to have the same directional impact on the dollar.
What this suggests is:
- The market cares more about nominal yields than about real yields, but it does watch both.
- Correlations are slightly higher on average for shorter-dated nominal yields, but progressively higher for longer-date real yields and breakevens – presumably on the assumption that inflation isn’t likely to change or even make that much of a difference in the short term, but is important longer-term.
- Expectations of higher inflation are not necessarily negative for the dollar.
How have these sensitivities changed recently? The biggest change is in the correlation for AUD and NZD. Over the longer term these are among the highest, but recently, as USD yields moved above AUD and NZD yields, the correlation has been almost insignificant. Apparently AUD and NZD are no longer trading so much on interest rate differentials as they are on domestic economics and global risk sentiment, as we see today.
Not much on the schedule today. Only one minor bit of data during the European and US days. Several speakers, but don’t look for anything exciting.
Retiring ECB VP Vitor Constancio is a busy guy today – first he makes closing remarks at an ECB colloquium being held in his honor, then 1 ½ hours later he makes the opening address at the third annual ECB macroprudential policy and research conference. The two events are being held in the same building, so he should have no problem getting there on time.
The Philadelphia Fed survey is expected to be down slightly but to remain firmly in expansionary territory. This compares with Tuesday’s Empire State index, which had a similar forecast but wound up rising notable.
Minneapolis Fed President Neel Kashkari (non-voter) will speak at a moderated Q&A session. He often speaks and he always says the same thing, which is basically that interest rates shouldn’t be raised during the Subatlantic chronozone, our current geological age. We can safely ignore him as his view is far from the consensus on the FOMC, which is slowly moving towards four hikes this year.
Bank of England Chief Economist Andy Haldane will give the closing remarks at a conference on economic measurement. The conference will cover all aspects of the measurement and use of economic statistics. I admit, this conference probably won’t get as much press coverage as the Eurovision Song Contest did. But Haldane could say something interesting about the bias in statistics and how the Bank of England adjusts for it, or which statistics it’s looking at particularly closely, which could be useful. Then again, he might just launch into a discussion of the pros and cons of STL vs X-12 ARIMA seasonal adjustment. In that case, I vote for Netta.
Dallas Fed President Robert Kaplan (non-voter) will speak in a moderated Q&A session somewhere in the heart of Texas. He just spoke on Tuesday, so I don’t expect anything new from him today.
Finally something (kind of) interesting today – overnight we get Japan’s national CPI. Inflation is forecast to fall back notably, as it did with the Tokyo measure, which comes out about a week earlier (the purple line in the graph). The slowdown in core inflation is likely to be particularly disappointing for the Bank of Japan.
But what can they do? They’ve already eviscerated their 2% inflation target by removing the deadline for achieving it. Now after around 24 years of core inflation at 0.5% or below (except for times when they raised the consumption tax), their promise to hit 2% inflation is as believable as Chiang Kai-Shek’s vows to retake the mainland. Only one member of the Policy Board is urging any change in policy to deal with the consistent misses. Nevertheless, a slowdown in Japanese inflation could be negative for the yen.
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