EUR/USD: Long-Term US Treasuries in the Driving Seat, and this Signals Downside

A high correlation between EUR/USD and the outlook for long-term US interest rates suggests investors could be more sensitive than usual to longer-term macro factors, and this spells downside potential into year-end.

Different drivers move an exchange rate at different times.

Sometimes politics is the main driver, such as after the French presidential election when EUR/USD surged higher on the basis that the 'Euro' was saved after Macron's victory. 

At other times the difference between interest rates can be the primary driver as investor funds tend to flow from low-interest rate to high-interest rate environments, where they can sit and earn a higher return.  

When it comes to what is driving the Euro-to-Dollar exchange rate in Autumn 2017, it appears investors are looking to the longer-term macro-economic picture according to new analysts from Deutsche Bank.  

More precisely, analyst Robin Winkler based in the German bank's London unit argues they are trying to assess where US interest rates are going in the long-term or to use financial market jargon, where the 'terminal rate' will be.

The 'terminal rate' is the level at which a central bank decides to stop raising interest rates any higher and this is usually shown in the yield on longer-term bonds, such as ten-year US Treasuries.

(Winkler's conclusions appear to be similar to those of SEB's Richard Falkanhall who also discovered a link between EUR/USD and longer-term US interest rate expectations).

What Matters for the EUR/USD

The reason we know investors are looking at the longer-term picture is because of the current high correlation between EUR/USD and 10-year US treasury bonds.

The EUR/USD shows a greater correlation to US Treasuries than to German Bunds or the difference between Bunds and Treasuries (the spread).

More than that, EUR/USD is being driven by where investors think US rates will end up - i.e. longer-term Treasuries. Below is a chart showing the percentage correlations of different assets to EUR/USD at different times.

The first column shows correlations between 2012 and the start of 2017.

During this time EUR/USD tended to trade as a function of the difference between interest rates as shown by the high correlation with the yield differential between Euro and US bonds.

The second column shows the period between April and September 2017 when the French elections were held and political risk was the main driver for the pair.

During this time correlations broke down across the board as pure politics dictated the moves in the currency pair.

Finally, the third column shows the most recent period from September 7 till now.

In this column, we note how EUR/USD has once again started to move more as a reflection of investors expectations about interest rates - more accurately US rates.

"Since President Draghi's half-hearted jawboning at the ECB meeting on 7 September, EUR/USD has taken its cue from yields again. But our correlation dashboard suggests that Eurozone rates remain unimportant for FX. Rather, the restoration of the correlation with rate spreads to long-term levels of 70-90% has been driven by US rates, which have had twice as strong correlations than in the years leading up to the correlation breakdown in the spring," says Winkler. 

Winkler goes onto to highlight how the closest correlation at 89% is between 5 and 10-year Euro/US bond differentials and EUR/USD, followed by 10-year US Treasuries on their own and EUR/USD at 86%.  

Based on this analysis Winkler concludes that there is a higher risk now that EUR/USD will fall into year-end.

This is due to the possibility that tax reform will come into being, which will increase spending and probably put upwards pressure on inflation.

Higher inflation will then lead the Federal Reserve to raise interest rates.

However, Deutsche's models indicate that a move far below 1.15 is unlikely.

Nor do they see exchange rates falling back down to 'fair value' of between 1.05-1.10 as implied by longer-term rate differentials, because of "the perceived improvement in Eurozone risk premium relative to the US," said Winkler.