How bond yield differentials drive cross-currency trends?

As economies lost momentum last year so did the global bond yields, notably US Treasury 10-year, which touched low of 0.31 per cent in March, 2020. They later recovered as governments and central banks started rolling out stimulus.

Yields do reflect growth expectations, which eventually drives the inflation trend. Yields matter in the foreign exchange market, as broad currency moves are driven by expectations of the central bank monetary policy stances.

In developed economies, if the rate-setters turn hawkish in their rate guidance, the currency of that economy tends to move higher relative to currency whose central bank lags behind in raising interest rates. Currently, yields have been the prime drivers of various currency pairs, especially those used in India, as non-rupee pairs, also called as cross pairs such as EURUSD, GBPUSD, USDJPY, etc.

Let’s take the example in EURUSD, where the euro is getting weaker since the beginning of February. The bond market and inflation expectations in the US are outpacing those in the euro zone. Accordingly, US Treasuries are yielding more than German bunds, and hence attracting funds to the US, strengthening the US dollar versus the euro.

This yield differential narrowed in the first month of the Covid situation, but at 2 percentage points, it has now risen to where it started last year. The dollar has strengthened along with it. Nevertheless, the market has more confidence in the US Federal Reserve’s ability to create inflation than it does in the European Central Bank, and so the dollar is rising.

Recently, the same scenario played out when the New Zealand government took measures to cool off rising housing prices, thus reducing inflation expectations drastically. Accordingly, New Zealand benchmark yield got pushed lower by 10 bps and, thus, on a relative basis with US yield, New Zealand dollar plunged over 2.4 per cent in two sessions.

The bond market is usually a leading indicator of price movements in cross-currency pairs. However, emerging currencies react differently on higher yield expectations, as the cost of carrying equity reduces substantially and foreign flows tend to reverse course in a higher yield environment. Cross-currency moves are driven mostly by yield projections for the near term, as risk sentiment evolves in the market.

(DK Aggarwal is the CMD of SMC Investment and Advisors)

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