Euro and Yen: Looking for a Black Cat in a Dark Room

Never known for being easy, the euro and yen seem particularly difficult to understand presently. During such times it is often best to return to basics. Foreign exchange reflects the cost of money. So do interest rates. The relationship between the two is not always clear and stable. Recently there have been some shifts in those relationships that market participants should be aware of.

Turning to the euro first, we note that yesterday the US-German 2-year differential poked through the 10 bp level. The US 2-year yield moved above Germany's in mid-December 2011 and has remained generally above there this year except for a brief exception in early Feb. The US premium yesterday was the high for 2012 and even now at 8 bp it is about 2x the 20 day moving average.

Yet the euro has trended higher. We find this to be an anomaly. On a 30-day rolling basis since early February, a wider premium for the US has been correlated with a stronger euro. This positive correlation (conducted on the level of the euro and the level of the interest rate spread) is rare. It occurred twice briefly last year and once in 2010. The correlation stands just below 0.43 today, which is the highest since Jun 2009.

The last time the correlation was positive was in the second half of Aug 2011. We know with the benefit of hindsight that the correlation broke down and, as interest rate differentials moved more in the US favor, the euro fell.

In a somewhat less rigorous fashion, we find it is more the case that the euro is overvalued relative to the change in the 2-year interest rate differential, than the interest rate differential is too wide given the euro's level.

That said, there are a number of observers suggesting that the backing up of US rates in the past couple of days is largely a function of Bernanke, who in congressional testimony seemed less dovish than in the recent past. Some have gone further and claim the risks of QE3 have declined.

We have maintained that the bar to QE3 was high in any event and we did not think it was the most likely base case. However, we do not see anything in Bernanke's testimony to suggest a change in his stance:  Economic growth is disappointing and more stimulus may be needed, even if not immediately, for the Fed to meet its statutory objectives.

Indeed, most recently we have argued that the rise in oil prices and gasoline prices presents a new headwind for the economy, which if sustained, could provide the doves at the Fed (and they include most of the governors and several presidents) a new reason to expand the balance sheet.

Realpolitik considerations suggest that the Fed will not deny itself a policy tool that it argues has been effective while it still plays up the downside risks to the economy. In a larger sense, the use of central bank balance sheets may be a permanent addition to their tool kits going forward. Just like the Great Depression led to a permanent role for the government to support aggregate demand, so too the Great Recession has produced a policy response that may have been unorthodox, but may become part of the orthodoxy.

Let's look at the yen. The BOJ governor acknowledged less than a year ago that the dollar-yen rate was highly correlated with 2-year interest rate differential. That differential reached 19 bp earlier today, which is the highest since last August.

The correlation between the yen (yen against the dollar, not dollar against the yen) is -0.90 today. That means as the interest differential widens, the yen tends to depreciate. That inverse correlation is the strongest since last May. In the last two months of 2011, the correlation was positive not inverse.

Between the relatively constructive US economic data, higher oil prices, and now some ideas that Bernanke is signaling a shift in stance, US yields have risen. The 2-year remains anchored by the near zero overnight interest rate and the belief that rates will not be hiked any time soon. Still, the US 2-year yield has risen from about 20 bp at the end of last month to 30 bp in recent days.

The BOJ surprised the market by extending its asset purchase program on Feb 14 and decline in the 2-year  Japanese yield that it spurred also served to widen the spread. However, the recent Japanese data, including retail sales and industrial production suggests an economic recovery in the current quarter.

The risk then is that the 2-year interest rate differential between Japan and the US narrows and that this weighs on the dollar against the yen.