FX Strategy. It s All About Yield Spreads (Or Not?)

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1 Global Economics & Markets Research URL: FX Strategy It s All About Yield Spreads (Or Not?) Tuesday, 06 March 2018 Heng Koon How, CAIA Head of Markets Strategy Heng.KoonHow@uobgroup.com Peter Chia Senior FX Strategist Peter.ChiaCS@uobgroup.com Yield spreads or rate differentials are one of many indicators offering an insight into currency movements. In simple terms, currency pairs tend to correlate better with changes in yield spreads. However, due to the presence of other dominant drivers, currency pairs may not necessarily move in line with yield spreads. Some examples include anticipated changes in monetary policy, changes in underlying trade patterns, investor flows or basic balances. This strategy note covers a brief discussion of four key pairs of yield spreads that have caught investor attention recently. Both USD/JPY and AUD/USD appear to have dislocated from their underlying 10 year yield spread. The JPY has recently strengthened despite yield spread moving in flavor of the USD. This further strength in the JPY may signal increasing market skepticism over the BoJ s commitment to maintain yield curve control. The AUD has not weakened as much despite yield spread moving against it. Strong bulk commodity prices may have helped to buffer the AUD against this deterioration in yield spread. On the other hand, USD/HKD trades very well in line with the widening spread between 3M US Libor and 3M HK Hibor rates. Spot has now risen to 7.83, as this 3M spread widened to 95 bps. The HKMA may well need to issue additional bills to ensure that Hibor rates do not fall too far behind the strong rise in US libor rates. Finally, the recent tentative consolidation in 10s2s US Treasuries yield spread has offered some respite to the USD. As the 10s2s US Treasuries yield spread stabilized above 50 bps over the past month, the DXY Index was able to hang onto the 88 to 90 trading range. However, most would agree that it is still premature to call for a sustained rebound in the USD. Tuesday, 06 March Page

2 USD/JPY Has Weakened Despite Rising Yield Spread The Bank of Japan (BoJ) adopted Yield Curve Control (YCC) in Sep 2016 with policy rate in the front end at -0.1% and longer dated target of around zero for 10 year JGB yield. Since then, 10 year JGB yield has been effectively capped below 10 bps. As a result, with 10 year JGB yield locked in below 10 bps, USD/JPY spot tends to move in line with the gyrations of 10 year US Treasuries yield. This relationship held firm until about the start of the year, but has since broken down thereafter. Since January this year, 10 year US Treasuries yield has climbed higher, from the 2.40% handle to the current 2.80% handle. However, USD/JPY spot did not trade higher, but instead headed lower from 113 to 106. Risk aversion in global equities market, coupled with increasing tension in global trade relationships have renewed the allure of the JPY as a safe haven currency, leading to recent JPY strength. More importantly, in the face of rising global yield, there has been increasing market skepticism over the commitment of the BoJ in maintaining YCC. Indeed, after his reappointment, BoJ Governor Haruhiko Kuroda conceded in his latest comments to Japanese lawmakers that the BoJ may well consider an exit to easy monetary policy in FY 2019, should Japan s inflation rise further to meet the long term target of 2.0%. Is this dislocation between USD/JPY spot and its underlying 10 year yield spread a sign of possible change of heart from the BoJ? Chart 1A: 10Y US Treasuries Yield vs 10Y JGB Yield - 10Y US Treasuries Yield 10Y JGB Yield Chart 1B: 10Y UST - 10Y JGB Yield Spread vs USD/JPY Spot USD/JPY Spot Spread Between 10Y US Treasuries vs 10Y JGB -RHS Tuesday, 06 March Page

3 AUD/USD Has Dislocated From Its Narrowing Yield Spread The on-going strong rise in 10 year US Treasuries yield has also affected the yield spread for AUD/USD. While 10 year US Treasuries yield climbed further over the past year, 10 year Australia government yield was stagnant in range trade in-between 2.5% to 3.0%. The 10 year Australia government yield went nowhere because Australia s inflation indicators remain benign and wage growth in Australia remains weak. As a result, the Reserve Bank of Australia (RBA) has repeatedly highlighted that it is comfortably on hold and is in no hurry to join the US Federal Reserve in raising rates. Consequently, this 10 year yield spread between 10 year Australia government benchmark and 10 year US Treasuries has narrowed over the past two years and the relationship between AUD/ USD spot and this underlying yield spread has started to tear. Since the middle of last year, as this yield spread continued to narrow, AUD/USD has traded higher instead, in line with stronger commodities prices. Most recently, this yield spread flipped into negative since the start of February and was widely touted as a key reason why AUD/USD was unable to sustain January s gains above, but has obediently pulled back to current levels of As mentioned above, nominal yield spreads can remain dislocated for extended periods of time, when there are other more influential factors in play. We maintain our view that AUD/USD is more likely to trade in line with bulk commodities prices, which remain well supported by the on-going global synchronized goldilocks recovery. Chart 2A: 10Y US Treasuries Yield vs 10Y Australia Government Yield 10 Year US Treasuries Yield 10 Year Australia government yield Chart 2B: 10Y UST - 10Y AUS Yield Spread vs AUD/USD Spot Yield Spread between 10Y AUS government yield vs 10Y US Treasuries yield AUD/USD Spot - RHS Tuesday, 06 March Page

4 USD/HKD Spot Rises To 7.83, In Line With Widening 3M Yield Spread On the other hand, in Hong Kong, the behavior of USD/HKD spot seems to be pretty much in line with the underlying movement in short term yield spread, particularly in the front end. Over the past two years, 3M US Libor has made a strong climb from 0.5% to 2.0%. However, due to abundant domestic liquidity, the 3M HK Hibor rate has made a more muted climb instead. As a result, this 3M yield spread between short term USD and HKD money market rates has widened further and USD/HKD has traded higher, rising from 7.76 in the middle of last year to 7.83 now. This makes sense. Due to the currency board arrangement, i.e. HKD is pegged to the USD around 7.80, the HKD is particularly sensitive to rising US rates and tends to weaken in line with rising US rates. It is worth noting that this 3M yield spread has now widened to about 95 bps and is significantly wider than the 60 bps handle in 3Q last year when the Hong Kong Monetary Authority (HKMA) last issued additional bills to soak up domestic liquidity. That intervention worked briefly in 4Q last year as USD/HKD fell back from 7.79 to 7.76, following the rise in 3M Hibor rate from 0.75% to 1.20% after the issuance of the additional bills. Since then, the further strong rise in 3M US Libor has resulted in a further widening of the 3M yield spread. At the rate in which this 3M yield spread is widening, USD/HKD spot may well test the upper bound of 7.85 in the coming few months. Will the HKMA be forced to issue more bills? Chart 3A: 3M US Libor vs 3M HK Hibor 3M HK Hibor 3M US Libor Chart 3B: 3M Libor - 3M Hibor Rate Spread vs USD/HKD Spot USD/HKD spot Rate Spread Between 3M US Libor vs 3M HK Hibor - RHS - Tuesday, 06 March Page

5 Stabilizing US10s2s Yield Spread Offers A Temporary Respite To The DXY Strictly speaking, this is not a nominal yield spread between two currencies, but is more of a calendar yield spread. The yield spread between 10 year Treasuries and 2 year Treasuries has been widely covered and debated at length. Over the past two years, this US10s2s yield spread has narrowed dramatically from 150 bps to as low as about 50 bps at the start of this year. The on-going narrowing of this US10s2s yield spread was widely cited as a key driver for USD weakness. Indeed, the USD Index (DXY) fell in tandem from 103 to the current level of about 90. This US10s2s yield spread has been rather volatile over the past month, spiking to nearly 80 bps before pulling back to 60 bps. The DXY has taken this opportunity to try its best to stabilize around the 88 to 90 level. However, despite near term consolidation, most would agree that it is still premature to call for a sustained rebound in the USD. Chart 4A : 10Y US Treasuries Yield vs 2Y US Treasuries Yield 10Y US Treasuries Yield 2Y US Treasuries Yield Chart 4B: US10s-2s Yield Spread vs DXY Index DXY Yield Spread Between 10Y US Treasuries vs 2Y US Treasuries - RHS Disclaimer: This analysis is based on information available to the public. Although the information contained herein is believed to be reliable, UOB Group makes no representation as to the accuracy or completeness. Also, opinions and predictions contained herein reflect our opinion as of date of the analysis and are subject to change without notice. UOB Group may have positions in, and may effect transactions in, currencies and financial products mentioned herein. Prior to entering into any proposed transaction, without reliance upon UOB Group or its affiliates, the reader should determine, the economic risks and merits, as well as the legal, tax and accounting characterizations and consequences, of the transaction and that the reader is able to assume these risks. This document and its contents are proprietary information and products of UOB Group and may not be reproduced or otherwise. Singapore Company Reg No Z

FX Strategy. Is CNY Strength Over?

FX Strategy. Is CNY Strength Over? Global Economics & Markets Research Email: GlobalEcoMktResearch@uobgroup.com URL: www.uob.com.sg/research FX Strategy Is CNY Strength Over? Friday, 09 February 2018 Heng Koon How, CAIA Head of Markets