Great Graphic: Two-year Rate Differentials

Given that some of the retail sales that were expected in June were actually booked in May is unlikely to lead to a large revision of expectations for Q2 US GDP, the first estimate of which is due in 11 days.  Before the data, the Atlanta Fed's GDPNow projects the world's biggest economy expanded at an annualized pace of 3.9% in Q2.  If true, it would be the strongest quarterly expansion since Q3 14, when the economy grew 5.2% after a 4.6% pace in Q2 14.  The St. Louis and New York Fed's GDP trackers estimate Q2 18 growth at 2.9%.  The early median forecast from the Bloomberg survey sees 4% growth. 

The US two-year yield edged to a new multi-year high today above 2.60%.  It has been struggling there since mid-May.  The Fed funds target is 1.75%-2.0%.  There is nearly a 90% chance discounted in the Fed funds futures strip of a September rate hike.  There is about a 60% chance of a December hike that is also reflected in the current strip, which would take the Fed fund target to 2.25-2.50%.  That would seem to make the two-year yield still relatively low if one expects at least one hike next year and no cut in 2019.  

We noted last week how the implied yield of the December 2020 Eurodollar futures slipped below the implied yield of the December 2019 contract.  It is at two basis point discount.  If anything, assuming no expectation of a change in policy, one would still expect a "natural" premium on the longer tenor.  This means that the risk of a cut may be a bit more than two basis point spread, 

The Great Graphic shows the two-year interest rate differential between the US and four countries.  The white line is the differential with Germany.  It is at a new record high today, above 3.22%.  From the beginning of last year, through September, the spread was flat near 2.00%.  Since then it trended higher.  It has not fallen more than one week a month this year.  In fact, the two weekly losses to finish last year were the first declines since early September 2017.   The ECB has indicated that although its asset purchases may stop at the end of this year, it does not envision a rate hike until at least Q3 2019.  It is still a year away.  Conservatively, the Fed will hike 2-3 more times before the ECB moves, and when it does move, it will likely be a small move beginning with a minus 40 bp deposit rate.  

The two-year German yield is near minus 65 bp today.  It is not the lowest.  The on-the-run Dutch two-year note yields minus 66 bp, while Switzerland's 2-year yields almost minus 80 bp.   Japan traditionally has the lowest yields, but that is history.  Its two-year yield is minus 14 bp,  This means that the US offers about 2.73% more than Japan (green line). It is the highest since 2007, but it is far from a record high.  In fact, in 2006, the US offered almost 4.50% over Japan. In 2000, the premium appears to have peaked a little below 6.60%.  The Bank of Japan may be reducing its bond purchases, but with low inflation and a retail sales tax increase for October 2019, which in the past hurt the economy, a rate hike is still beyond the horizon.  

The two-year spread between the US and UK is the green line.  It is near 1.84% today, a sliver away from month's peak, which was a record.  Over the last several weeks, the market has become more confident of a BOE hike next month.  The implied yield of the September short-sterling futures contract has risen 15 basis points in the last six weeks or so.  There may be some scope for the UK yields to increase a bit more, perhaps in reaction to this week's slew of data.  However, the BOE does not appear to be in a position to accelerate its rate normalization.  This means that the two-year interest rate differential can move more in the US favor.  

The red line is the two-year interest rate differential between the US and Canada.  The multi-year high was set in late June a little more than 76 bp. In recent years, the spread stalled in near 60 bp.  It had reached around 100 bp before the Great Financial Crisis and was above 200 bp briefly in 1997.   The Bank of Canada is the only major central bank that might be able to match the two hikes the Fed anticipates on delivering in H2 18.  The Bank of Canada raised rates last week, and the market is pricing in about a 60% chance of a hike in Q4, which we think is an appropriate assessment at this juncture.  

As a simple examination of the currency's sensitivity to the two-year differential, we ran correlations (60-day) on the value of each.  The euro and the 2-year differential move in opposite directions most of the time.  The correlation stands at -0.69 today.  It troughed near -0.88 in June.  The correlation between the sterling's exchange rate and the two-year differential is near -0.89 today.  It was near -0.95 at the end of June, which is the most extreme in several years.  

The dollar-yen exchange rate and the two-year rate differential correlation stands just below 0.75 today after peaking near 0.95 last month.  The US-Canadian dollar correlation with the two-year interest rate spread is near 0.85 today.  It peaked in Q3 last year (near 1.0) when the Bank of Canada began hiking rates.  

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