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Two-Year Rate Differential And The Euro

By ForexJan 31, 2013 06:15PM GMT Add a Comment
 
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We constructed this Great Graphic on Bloomberg. It shows the collapse of the premium the U.S. offered over Germany on two-year government obligations. It also shows how shifting interest rates weighed on the dollar against the euro.
<span class=USD/EUR And Two-Year Rates" width="736" height="527">
More broadly, it shows how the dollar's exchange rate against the euro tracks the two-year interest rate differential fairly closely. It does not track tick-for-tick and divergences are often noteworthy, such as in early December when the spread made highs in the dollar's favor, but the did not lend the dollar more support against the euro. Nevertheless, we find this to be one of the best guides for the general direction of the most actively traded currency pair.

An alternative driver, some suggest, the RoRo (risk-on/risk-off) that links the euro to the S&P 500. Yet, as we have noted, the euro's correlation with the S&P 500 has broken down. Using a 60-day rolling correlation on the percentage change of the euro and percentage change of the S&P 500 (thus correlating returns), at 0.27, the correlation is the lowest since March 2011. It peaked in late 2011 near 0.85.

Looking closer at the chart, one can see that the two-year rate differential has stopped falling and appears to have entered a choppy consolidation phase. The ECB meeting next week, and more importantly, Draghi's press conference, is likely to push back against the passive tightening of euro zone monetary conditions, but a rate cut to offset the tightening would catch the market by surprise.

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