Great Graphic: US-German 2-Yr Differential and the Euro

This Great Graphic
from Bloomberg shows two time
The white line is the spread between the German two-year
interest rate and the US two-year yield.  The yellow line is the
euro-dollar exchange rate.    Two different scales are needed as
when the times series are indexed; the
relative volatility is such that the details cannot be observed.  

The German discount to the US reached 152 bp
today, which is a new high extreme since 2006. 
The pre-crisis peak
was actually in 2005 near 185 bp. 

The chart covers the movement of both time
series over the past year.
  Because of the optical illusion of making
one chart with two times series and two scales, it may not be particularly
robust analysis, but its cautions against
putting too much emphasis on co-movement of the two.  Nevertheless, the
divergence is striking.  Since the end of July, the euro has appreciated
from below $1.10 to $1.12-$1.13.  The two-year differential has widened to 152 bp from 125.  

There are many cross current flows and other
distortions, like the cross-currency swap
rate, which the BIS discussed here.

Nevertheless, over time, the widening premium in the US favor will likely give
the greenback better traction, though of course there is not a one-to-one
correspondence between a particular interest rate level and a euro-dollar
exchange rate.  

After a very strong service sector ISM and
better than expected factory/durable goods orders, and a meh of an ADP report,  expectations for Fed
policy have barely changed. 
Bloomberg says the odds of Nov hike
increased to 23.6% from 21.4%.  The CME’s calculation puts the odds at
16.6%, up from 14.5%.     The odds of a December move have been
pared to 50.2% (from 50.3%) for Bloomberg, while the CME puts it at 54.8% (from

Where we stand
We think there is a de minimis chance of a November hike.
  There is no
precedent for a hike a week before a national election.  This is one way how the Fed traditionally
demonstrated its political neutrality.  It would not change policy so
close to an election.  It does not mean that the Fed cannot do so, but it
suggests that it would need a compelling reason to break from tradition. 

Moreover, remember the corner the Fed has
painted for itself. 
It will not change policy without a press
conference.  There is no press conference after the Nov meeting.  A
rate hike then does not only require a break from tradition, but it also
requires a logistical challenge of having a last minute press conference
without word leaking.  

On the other hand, we think there is a strong
chance of a hike in December and with the current odds, there is scope for
investors to discount a greater likelihood. 
A strong jobs report is
helpful, but before the December meeting, Fed officials will have two more
reports.  This week’s then may not
be the trigger for a dramatic shift in expectations, barring a blowout report.  


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