EUR/USD versus rates correlation re-establishing – Deutsche Bank

According to Robin Winkler, Strategist at Deutsche Bank, EUR/USD and rates correlation has re-established itself, but unlike in previous years, US yields are in the driving seat.

Key Quotes

“Between 2012 and the French election, EUR/USD had strong correlations of 70-90% against nominal and real rate spreads, especially in the front end. Most of these broke down following the French election, with the average dropping below 20%: the euro appreciated despite rates. Correlations against bund yields, which had been stronger since 2012, collapsed more drastically than against USTs. At first, inflows to the euro defied the rate spread as they were concentrated in equities. Later in the summer, flow-driven euro strength actively contributed to lower rates as it was feared to short-circuit ECB tapering.”

“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. What's more, the strongest correlations are now against longer-dated tenors, consistent with EUR/USD being increasingly sensitive to Fed terminal rate pricing. The timing of the next Fed hike or two, by contrast, no longer moves EUR/USD as strongly as it did in previous years.”

“This sensitivity to terminal rate pricing in the US means the risk remains skewed toward a weaker EUR/USD by year-end if progress on tax reform exceeds low market expectations. However, with our 3y1y proxy for terminal rate pricing only 20bps below the 2.3% top end of its range, the move is unlikely to extend much below 1.15. More broadly, the restoration of the rates correlation does not mean that EUR/USD should be expected to drop back to a 'fair value' around 1.05-1.10, as implied by the long-term FX-rates relationship. The structural break over the summer resulted from a perceived improvement in the Eurozone risk premium relative to the US. This is unlikely to be reversed even if US tax reform beats expectations.”