Taking stock after the bond sell-off in the second half of April

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In the first two weeks of May 2015 yields of US Treasuries and German Bunds have showed some tentative signs of stabilization after rising sharply in the second half of April (see chart 1 below).

Chart 1: Interest rates rose sharply in the second half of April.


Source: Bloomberg, as of 22 May 2015

While it is too soon to conclude that volatility will subside, it is an opportune time to survey the broader market impact of the rise in 10-year yields to multi-month highs. One of the more striking knock-on effects of the Bund-led rate shock has been the sharp appreciation of the euro against the dollar. As seen in chart 1 below, the move into quantitative easing (QE) by the European Central Bank (ECB) prompted a sharp decline in 10-year Bund yields and a widening interest rate differential with Treasuries. Unsurprisingly, this was accompanied by significant euro depreciation and expectations among many investors that the exchange value of the euro against the dollar could fall to parity by the end of this year. However, as the term premium on German Bunds repriced over recent weeks against the backdrop of some improvement in European data, the narrowing of interest rate differentials against Treasuries served as the prime catalyst for the 7% appreciation of the euro against the dollar.

Chart 2: The differential (spread) between 10-year interest rates in Germany and the US (blue line) and the exchange rate for the euro-dollar currency pair (green line).

10-year interest rate differential and euo-dollar currency pair

Source: Bloomberg, as of May 15, 2015

Continued negative data surprises in the United States have also contributed to recent dollar depreciation, as market conviction behind a September increase in policy rates by the Federal Reserve (Fed) has weakened. Perhaps reflecting increased uncertainty in the outlook, many Federal Open Market Committee (FOMC) participants have recently shied away from giving their best approximation of the timing of liftoff, and have instead stressed the data-dependency of their policy outlook.

If most investors now view Bunds as more fairly priced, what could prompt a return of the euro parity trade in currency markets? There are a number of longer-term factors that could lead to downward pressure on the euro over time. These include:

– continued expansion of the ECB’s balance sheet,

– recycling of the eurozone’s persistent current account surplus into foreign portfolio investments,

– the gradual shift of holdings away from euro-denominated assets by return-sensitive investors.

But as these factors play out over longer time horizons, the more likely near-term catalyst for euro depreciation might need to be an improvement in the US economic outlook and a firming of policy expectations. We will learn more when the minutes to the April meeting are released on May 20, but by all indications most Committee participants seem willing to look beyond weak data for the first few months of the year. Still, the outlook remains fairly uncertain. The Federal Reserve Bank of Atlanta’s “Nowcast” for second quarter GDP is just 0.7%, and three districts to the north, the Federal Reserve Bank of New York’s most recent forecasts call for growth over the remainder of the year of under 2.5% – hardly a strong recovery after a weak first quarter.

Even if growth comes in a bit under 2.5% for the rest of the year it would still be sufficiently above trend to allow a gradual fall in the unemployment rate, even if payroll gains remain short of the strong pace seen late last year. But this scenario could raise an uncomfortable scenario for the Committee, and investors. With growth showing no improvement over last year’s pace and inflation still contained, would an initial rate increase later this year be viewed by investors as premature? Risk assets thus far have been fairly resilient to the recent back-up in interest rates, with the S&P500 index at a fresh record high as but one example (see chart 3 below).

Chart 3: S&P 500 Index


Source: Bloomberg, as of 22 May 2015

Such performance might not hold if tightening commences with growth just slightly above trend. Against this backdrop, the FOMC’s June economic projections will provide an important clue to the outlook. If the Committee once again revises down its estimate of the longer-run (i.e. non-inflationary) unemployment rate, as it did in March, it would signal an increase in the assessment of labor market slack, and a further delay in liftoff.

Steven Friedman

Senior Investment Strategist

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