In a note to clients today, ING uses principal components analysis to show how the change in the relationship between yield spreads and FX rates could explain the recent atypical price action in EUR/USD.
EUR/USD: the anomaly of 10Y spread link.
"While market attention has been focused on developments at the long end of the curve, Figure 2 shows that currency pairs are beginning to recouple with their short-term rate spreads (back to levels observed in 2H14)," notes ING.
"EUR/USD is the only cross not to show this trend – its 3M correlation with the 10Y Bund:Treasury yield spread supersedes that of the 2Y spread. This is due to the unwind of popular QE carry trades," ING adds.
EUR/USD & rates spread: what's next?
"EUR/USD’s coupling with longer-term rates is likely to be a temporary phenomenon. Indeed, we see this week’s June FOMC as crucial in shifting the focus for markets back to short-term US rates and the theme of monetary policy divergence. Market pricing for the timing of a Fed lift-off has been moving in the right direction, with the probability of a 25bp rate hike in September increasing from 35% to 55% following the robust NFP and retail sales prints," ING argues.
"The anomaly of EUR/USD moving higher last week may insinuate pent-up USD strength and we see scope for a sharp move lower once the pair’s relationship with short-term rates normalises," ING projects.
