The steady increase in the US two-year yield while the market unwinds
rate hike expectations in Australia has pushed the US rate above Australia for
the first time since late 2000. In the past month, the US
two-year yield has risen by 15 bp, while Australia's has fallen by 13 bp.
But the narrowing of the spread, and now inversion, has been unfolding for the
past six years.
Moreover, we suspect there is room for divergence to extend well into
2018. Australia's case rate stands at 1.5%. With
the central bank likely on hold for an extended period, the two-year yield can
slip closer to the cash target rate. At the same time, the US two-year
yield is trading 50 bp above the upper end of the current Fed funds target and
25 bp above the range expected to be adopted next month. That 25 bp may be a reflection of the one rate hike
that the Fed funds futures strip appears to have discounted in full.
What is not priced in is the
likelihood of at least two rate hikes next year. We suspect the US
two-year yield can rise toward 2.0% and the two-year
Australian yield can ease toward 1.50%. The spread, which has just
turned in the US favor is likely to continue and could trend toward 50 bp in a coming couple of quarters.
What are the implications for the exchange rate? The Great Graphic
posted here shows the rolling 60-day correlation of the two-year interest rate
spread and the Australian dollar exchange rate. The correlation shown
here is on a purely directional basis. On days the differential
increases, the US dollar strengthens the vast majority of times. However,
the correlation is not stable, and you
can see that in three of the past four years, the correlation snaps and becomes
inverted for a short period. Still,
as the distribution chart on the right
shows that most of the time the correlation is above 0.60.
However, when we conduct the correlations on the level of percentage
change, the correlation recently broke down. The 60-day rolling
correlation has fallen from a little above 0.5 earlier this month to below 0.2
presently. It is the lowest in a little more than a year. This seems to reflect the fact that after
trending since early September, the Australian dollar traded broadly sideways
in the first have of November, and then made fresh lows on November 15-21. It recovered following the key
reversal on November 21 but posted an
outside down day yesterday.
The Aussie is near its 20-day moving average, while the two-year rate
differential has continued to sawtooth
move lower. The spread has not seen its 20-day moving average since
September 21. Taken together the two correlation studies show that while
the interest rate spread and the currency tend to move in the same direction,
the magnitude of the price movement has
become markedly different.
The Australian dollar's technical condition is modestly constructive.
The MACDs are turning higher. The Slow Stochastics have already turned up, and
in any event, did not confirm the recent new lows in the Aussie, leaving a
bullish divergence in its wake. Speculative positioning in the futures
market has adjusted in recent weeks. The gross long speculative position
has been trimmed by nearly 30% since the end of September., while the gross
short speculative position has increased by nearly 50% since the middle of
October. This resulted in a decline
in the net long speculative position from 77.2k contracts at the end of
September to just below 40k contracts as of November 21, the most recent
data. The net position is within a few hundred contracts of this year's
average.
Three-month implied volatility for the Aussie has fallen from near 11.8%
at the start of the year to about 7.25% at
of June. It was above 9.0% in August and September and has since
drifted back toward the year's low. It is currently a little below
7.5%. The three-month risk-reversal, which is the skew between puts and
calls equidistant from the money, favors Aussie puts, but by nearly the least
this year (~ 0.65%). It suggests a small bias that volatility is more
likely to rise if the Aussie breaks down than if it appreciates. The
correlation between the implied three-month volatility and the exchange rates
is 0.85 over the past sixty days.
Near-term, watch the downtrend line drawn
off the September 20 high (~$0.8100), the October 20 high (~$0.7880), and the
pre-weekend high (~$0.7640). The trend line was violated yesterday on
an intraday basis, but it closed below
it. A break below $0.7575 would suggest the attempt to stem the
nearly three-month decline has failed.
Disclaimer
Great Graphic: US 2-year Yield Rises Above Australia for First Time since 2000
Reviewed by Marc Chandler
on
November 28, 2017
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