Saturday, 25 January 2014

Forward Rates

Since the beginning of 2014 there has been a significance divergence in some of the forward rates for major currencies. This should be a key factor going forward for the FX markets as the guidance and expectation from Central banks should be a critical factor.

Below shows some 1y rate 1y forwards

1Y1Y rates for GBP, USD, EUR, CAD

As we can see here, CAD 1Y1Y rates have dropped by around 25bps, EUR rates down by 8 or so. Yet USD and GBP forward rates have risen marginally.

This divergence will be very important when looking to the medium term, as we can the fixed income markets start to react and so far, in FX, only the CAD has responded to the changes in central bank outlooks.

Since the taper though, the market has moved to from a state where it was considering the (at the time) present factors, and instead has moved to considering how these are going to change over the next 1/3/6/13 months etc.

This point can be illustrated by simply looking at the EURGBP, right off the bat there should be no obvious implications of a Fed Taper, there is no excess correlation with the USD between either of the EUR or GBP and as such it should have been a neutral event. But it wasn't.

EURGBP hourly

As we can below - the EURGBP has traded mostly in tandem with 1Y implied yields (from forwards) for the most part of the last 5 years. But these 1Y rates on show the current picture, when looking ahead now, we need to consider how they rates are going to change.

EURGBP 1Y implied yield vs EURGBP

That is why, since the Fed Taper - and pretty much since it became an idea in the early part of 2013, the EURGBP has been trading much closer to that of the 1Y1Y spread. (shown below)

1Y1Y spread vs EURGBP (red) and 50 day correlation

We can see the correlation moved from mixed to decisively red, where red shows a negative correlation (because the spread is inverted on the right axis)

As we can see that now looking at 1Y1Y rates are far more important than just 1Y rates as now investors are caring much more about the central bank path than pre-taper.

The reason why the taper is so important is it has acted as a psychological change from "uber-dovish" to "cautiously hawkish" and this means that the markets will start to consider the fact that base rates will soon be on the rise (as opposed to the idea that we've ZIRP ad infinitum).

Now in the case of the EURGBP the central bank divergence is pretty obvious - ECB have recently cut rates and will have to ease more, where as the day-by-day pressure on the BoE to hike is increasing (consider U/E recently). As such selling rallies in EURGBP should be good all year.

Another example is AUDNZD.

Here is a chart of the AUDNZD spot, AU-NZ 2 year spread, and the spread between the 2 year rate 1 year forward.

AUDNZD vs rates
Once again, since mid 2013, the AUDNZD has become far more correlated with the forward rate spread as opposed to the current spread. The divergence between the RBA and RBNZ is quite clear, but relatively minimal in comparison to others.

So, looking forward, using the idea that the market will start, albeit slowly, to noticing forward rates more and more the EURUSD looks to be a good sell going forward. So long as the rates factor becomes more important than the relative balance sheet and also the strong Current account position of the EZ.

But providing it does, the EURUSD will come under heavy pressure as the expectations widen more and more, and the yield spread widens to a point where the EURUSD can no longer justly trade at these levels.

Finally it would be easier to just pay USD rates and recieve EUR rates but it should filter through to the FX markets.

And here where the current implied yield is in Blue as well, we can see how it is very much like EURGBP pre 2013 where it only cared about now, as opposed to the future.

This is could be what we are looking at if the EURUSD starts to price in the future as opposed to the present. (ok maybe not 1.20, but under 1.30)

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