Mounting tensions on rates and currencies
by Raul Elizalde - 2015-05-05
After a strong 6-month rise and a huge early-March surge, the US dollar has stopped climbing against other currencies. The reasons: A significant change in the outlook for inflation and rising interest rates in the developed world. Whether this is a temporary break in a long-term trend or a sharp, V-shaped reversal is not clear. What is clear is that conditions for much higher interest rate and especially currency volatility in coming weeks are firmly in place.
The main driver of US dollar strength is the difference between US interest rates and rates elsewhere. Economists call these gaps “interest rate differentials”, and traders use them to price foreign-exchange futures. The relationship between interest rates and exchange rates is simple: people sell the currency of countries with low rates to buy the currency with higher yields.
Until recently, rates in Europe have been falling far more steeply than rates in the US, thus forcing a significant appreciation of the US dollar. While the US 10-year Treasury bond declined from above 3% in the beginning of 2014 to below 2% by the middle of last April – a huge fall – the German equivalent plummeted from just below 2% to practically zero – 0.07% – in that same time period.
One reason for this complete collapse was the implementation of Quantitative Easing (QE) by the European Central Bank. Following the example of the US Federal Reserve, the ECB started buying billions of euros of European high-quality bonds per month. Because of this extraordinary new demand the price of the bonds skyrocketed, and their rates, which move inversely to the price, plummeted.
Another reason was that inflation in Europe had turned negative. European consumer prices went down for four months straight. Producer prices, remarkably, have been falling since August 2013.
But this state of affairs changed quickly in the last month or so, as consumer inflation stopped falling. Along with indications that European economy benefited from a combination of a weaker currency, ongoing stimulus from the ECB, and positive effects of lower oil prices, German bond rates suddenly surged. This, in turn, halted the rise of the US dollar versus the euro. At the time of this writing the yield of the German 10-year Bund had gone up more than six-fold from a low of 0.07% to 0.45%.
Many issues will be crucial in determining where the dollar goes from here. One is how the Greek crisis gets resolved. Another one is the timing of US interest rate hikes by the US Federal Reserve.
By all accounts, Greece is running out of money and heading for a default. This happened not too long ago. At that time the country got a bail-out, restructured its bonds, and promised to clean its finances. Such happy outcome is far less likely today: Social outcry is mounting, as the country recently forced idle cash in state-owned hospitals and schools to be moved to the central bank to shore up a currency shortfall. Many Greek citizens demand that the country leaves the eurozone, which is perceived as demanding draconian measures that do little to resolve the crisis while driving Greeks deeper and deeper into misery.
German citizens see it differently, believing that lenders have the right to expect that Greece should honor its obligations. Many Germans, however, have a point of agreement with many Greeks: The time may be ripe to cut the ties and let Greece leave the eurozone.
If this happens, the euro is very likely to strengthen. This is because much of the ECB monetary stimulus is aimed at reviving the periphery – easy money that Germany does not need and has consistently opposed. A Greek exit could provide strong support to those who want to backpedal from monetary stimulus. This will lead to higher rates and thus to a stronger currency.
On the other hand, inflation expectations in the US have gone up substantially. While the interest rate differentials have benefited the euro in the last few weeks, the uptick in inflation figures could impact the timing of an interest rate hike.
We have said several times that a June hike was unlikely, and analysts and observers elsewhere have eventually come to the same conclusion. US economic weakness has been noticeable in the first quarter, at a time when inflation expectations were low. But if inflation expectations keep rising and US economic data releases show strength in the second quarter, US rates may finally start to rise. How this will impact the US dollar depends on how European rates move in relation to US rates. Predicting this is hard.
There is a tug of war between possibly higher rates in Europe (arising from higher inflation expectations and concerns about Greece), and higher rates in the US (stemming from higher inflation expectations and the timing of a US rate hike). On top of this, elections in the UK have added to the uncertainty as some say that they may lead to an eventual British exit from the European Union. The Tories have promised a referendum on whether the UK should remain part of the EU if they win. The Labor party has said that they may also call a referendum if the European Union makes further moves to transfer power from member states to the EU.
So the stage is set for much higher currency and rate volatility in the coming weeks and months. A further spike in inflation expectations, a Greek blow-up, noisy UK elections and a Fed rate hike are things to watch. Option traders deal with this uncertainty by making bets that the market will make a large move without having to bet on the move’s direction. Most other investors have to choose which way they want to position their portfolios and hope that they make the right bet. We have reduced positions in US bonds and scaled back bets on the US dollar. Others can’t be blamed if they choose to sit this one out until the dust settles.
Our clients want to make sure that their investments are managed efficiently and prudently, and that they partner with an advisor who helps them cut through the market noise. We look at their specific situations and use quantitative techniques and solid execution expertise to build and maintain investment portfolios that are suitable for their needs. We try to identify when to buy or sell different asset classes, with a focus on controlling downside, seeing through the haze of short-term volatility, and looking at what securities are priced favorably at various times. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more