Three Rate Differentials to Note

During this holiday period, participation is light and order-driven activity can push prices more than usual.  Investors should not let the noise and gyrations obscure the bigger picture.   We continue to place the divergence of monetary policy at the center of our narrative.     Barring a significant negative surprise from the labor market, we expect the Fed to hike rates again, with March as the most likely timeframe. 

We are cognizant that the recent US data has disappointed, and that the Atlanta Fed's GDPNow warns that the US economy is tracking 1.3% annualized growth in Q4.  A notable headwind that has emerged is weakness in residential investment.    This was the net result of last week's poor existing home sales report.  We suspect the weakness was exaggerated by a some rule changes and a recovery in likely December.    

On the other hand, the unusually warm winter weather throughout most of the country may also weigh on retail sales.  This may sound ironic.  After all,  some abnormally cold winters and a few winter storms were cited in the past as depressing retail sales.  Yet the opposite is not true.    The  warm weather does not bode well.  The unifying principle is that unusual weather distorts the seasonal adjustment, which is important in high frequency data. 

Some observers, frustrated with the lack of dollar gains since the Fed hiked rates, have turned bearish and the disappointing data would seem to play into their hands.  They argue that the divergence story is old and fully discounted.   

There are three interest rate differentials that are telling a different story.   We expect them to result in a stronger dollar.    

The first is the two-year spread between the US and Germany, which the euro tracks.  The US offered a premium of a little more than 75 bp a year ago.  It traded with a higher bias, but largely sideways until mid-October when it was just above 80 bp.  It rallied to almost 138 bp by early December and peaked the day before the ECB met.  It fell to about 122 bp on December 11.  It stands at 136 bp today.   The highest since the ECB meeting.   

We look for it to rise toward the 2005-2006 peak near 175 bp in H1.  In 2000 when the euro was being sold to record lows, the US premium rose to around 220 bp.   We recognize that there is not a one-to-one correspondence between a certain premium and euro-dollar exchange rate, but trend in the same direction.  Over the past hundred sessions, for example, the dollar and the premium over Germany have moved in the same direction in 88 of the sessions. 

The second noteworthy spread development is between the US and UK.  The US two-year premium has widened to 40 bp over the UK.  This is the largest premium since 2006 when it approached 50 bp.  In early November it stood at less than 10 bp.   Since then, sterling has been the second worst performing major currency against the US dollar, losing 3.3%. 

When the Fed disappointed investors by not hiking rates in September, the US briefly traded at a discount to the UK.    On the other hand, when sterling traded above $2.00 in 2008, the UK offered more than 250 bp more than the US.    Over the past hundred sessions, sterling and the UK discount to the US have moved in the same direction in 73 sessions. 

The weakest major currency since not only early November, but for the year as a whole as been the Canadian dollar.  It has fallen 5.7% against the greenback since early last month and is off 16.3% year-to-date.  At the start of the year, the US offered almost 40 bp less than Canada on two-year paper, and now offers 53 bp more, which is a new multi-year extreme.  

The widening spread in the first part of the year reflected two Bank of Canada rate hikes.  The most widening began in mid-October, when the US premium was 2 bp.  The widening reflects the increase in US rates, as the Fed hike was anticipated, with more hikes expected in 2016.   At the same time, disappointing Canadian data has renewed speculation of another Bank of Canada rate cut.   

In 2004 and 2005, the US premium was nearly 100 bp.  This is where it appears headed again.  The US premium poked through 200 bp in 1997.    Over the past hundred sessions, the US dollar and the premium over Canada have moved in the same direction near 82 times

This review of three interest rate differentials should not be understood as a mono-causal explanation of currency movement.  The decline in oil prices may offer related and separate impact on the Canadian dollar, for example.  The prospect of a UK referendum for mid-2016 may also be a factor impacting UK assets.   Nevertheless, the interest rate channel is an important driver of currencies, and sometimes, for analytic purposes it may be useful to consider them independently of other drivers.  

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